Investment Guru Warren Buffet once rightly said - "Cash and Courage combined, in a moment of crisis, are priceless". This simple line probably embodies 90 per cent of the 'wisdom' required to generate long term returns from the equity markets. It's no wonder then that Buffet is worth $66.7 Billion - most of it earned from the equity markets!
Global events have led to a significant drop in the Nifty since March 2015 (close to 18 per cent since the peak). This presents a great opportunity for long term investors to create wealth.
Although common sense dictates that we should buy more of something when it's cheap, and less of something when it's expensive - this is the exact opposite of what most investors do in real life. On the contrary, maximum retail inflows take place near the peaks of bullish cycles and the maximum outflows take place towards the end of bearish cycles. What's the reason? Emotions! We tend to get carried away by greed when everyone else has made money (and we haven't) and by fear when there are doomsday predictions galore.
Are stocks cheap or not?Unlike other commodities, gauging whether stocks are 'cheap' or not isn't a simple task. A stock priced at Rs. 300 could be expensive whereas another stock priced at Rs. 3000 might be cheap. Similarly, the Nifty (the benchmark stock market index) may be expensive at 6000 but cheap at 8000, depending upon what point in time that we are referring to. Technical Analysts may be signaling an exit from the markets whereas Fundamental Analysts may be recommending an entry into the markets. In this confusing situation, are there any thumb rules that retail investors can apply?
The PE (Price to Earnings) Ratio of the NiftyIn layman's terms, the "PE Ratio" of the Nifty is the number of times current annual earnings that the overall market is trading at. In overheated (bubble) markets, this number can exceed 25. This means that the market is expensive and you are likely to earn a poor return if you invest at this time. As more and more people start selling (usually in panic), stock prices fall and a semblance of rationality returns to the markets, resulting in a drop in the overall PE Ratio. In the range of 15 to 20, the stock markets are quite fairly valued and one can consider making lump sum investments with a good chance of generating long term returns. Below 15, the market is undervalued and one should seriously consider allocating a larger portion of their savings to stocks. (At the time of writing this, the Nifty PE is 19.86)
Source: http://www.nseindia.com/products/content/equities/indices/historical_pepb.htm Stick to Mutual FundsWhile it's tempting to trade in stocks based on tips and hearsay, we believe most retail investors should stick with Mutual Funds. In a market with a reasonable PE ratio, we would go a step further and suggest that one should stick mainly with Blue Chip Mutual Funds that invest in the "heavyweight" companies or stable bellwethers of the industry. Mutual Funds are run by experienced Fund Managers and offer automatic stock picking and diversification across a well-researched set of stocks, improving your chances of earning a higher return over the long term when compared to investing in stocks by yourself. In a nutshell - when markets fall, take the opportunity to invest lump sums into Blue Chip Mutual Funds!
Give it Five YearsThis is probably the most important part of the formula. Having gauged whether the market is "cheap" or not and having made an informed decision to invest in Blue Chip Mutual Funds, you now need to assume that the stock markets are closed for five years! There's no guaranteeing how markets behave in the short run, (as Keynes put it: "Markets can remain irrational longer than you can remain solvent") and you may in fact run into short term losses. Holding on for five years or more will greatly improve your chances of making returns. Don't churn your funds frequently, don't fall prey to emotions and don't act impulsively upon wrong advice - and you'll be all set to benefit from market dips while others sell off in panic.
