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Pitfalls of Market Cycles

Investors ably micro-manage their stock and fund holdings, but they fail when they try to chart the wider trends

 Investing well requires a combination of skills of different kinds. Broadly, these can be broken up into figuring out which stocks, or funds, will do well on the one hand and figuring out broader, market-wide or economy-wide trends on the other. After years of observing the markets and investors, I have formed a firm belief that while the former is well within the capability of many investors - both amateur and professional - the latter is practically impossible to do on a sustained basis.

What makes this important is that investors who do the first part right often lose money and give up gains by trying to do the second part. In theory, this boils down to choosing the right funds and then trying to redeem when you think the broad market is going to go down. On the way up, this means sitting with cash, waiting to invest till the last moment before the markets start rising. In practice, for most investors who try and do this, it means selling their funds after the markets have crashed and buying them back after they've shot up. The last couple of years have seen a particularly severe version of this cycle, with the latest drama being played out right now.

Typically, this leads to dramatically lower gains, even if you hold your investments for a long term. Let's take the example of the period from January, 2008 till now. This kind of a pattern would mean that an investor would have caught most of the decline from the peak in January, 2008. Then, waiting for the markets to go up, he would have missed the sudden upsurge in May, 2009 but would have caught the decline over the last few days. This is not hypothetical - there are countless investors who are going through this same sad rollercoaster.

Interestingly, this is not limited to individual investors. Professional investment managers too make such mistakes with great regularity. The reason is simple, yet a little hard to accept. It isn't too difficult to identify a good stock or fund, but predicting general ups and downs is complicated. In fact, it is arguable that general ups and downs are not predictable with a degree of useful certainty. More importantly, I've observed that there's no commonality between stock- or fund-picking skills and the skill of being able to figure out broad movements. Someone could be a great investment analyst but that doesn't say anything about his or her ability to pick out broader trends.

What this means is that as an investor, one should accept that its best to stay invested and to keep investing at all times. Improving one's returns by timing the broad markets is an illusion and there is no point in trying to chase it. This is difficult to accept because it all looks so easy in hindsight. It was 'obvious' that the markets tank in January 2008, just as it was obvious that the sub-prime crisis would balloon into a global fiasco and that the UPA would win the elections and so on and so forth. Except that it wasn't, and you'd better admit it.

It's little use putting effort into choosing a great fund or a stock and then throwing it all away by double-guessing things that can't be predicted. Investors should decide how much of their money should be in equities and then stick to that through thick and thin.