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Danger Ahead in Rising Markets

If the good times are coming on the investment markets, sharp-eyed salesmen can't be far behind

Now that there's a distinct prospect of a long rally in equities, there's serious danger ahead for investors. That sounds like a contradiction. If equity markets are going to rally, and investments in stocks and equity mutual funds are going to make money, then how can it be a dangerous time for investors? To answer that question, ask yourself what your own investing experience from 2002 to 2010 was.

There were the happy years from 2002 when everyone made money on everything. Then came the crash, and everyone lost, money on everything. However, then came the recovery and brought many surprises with it. Many investors were shocked when they realised that when equities recover after a deep crash, it's not really a recovery, it is a completely new situation. The word recovery implies almost a winding back of the clock, a restoration of the previous situation, sort of like pressing Ctrl-Z on the computer. But that's not the way things really were. The shape of the equity markets changed completely after the recovery.

Many of the investments that did the best during the boom never recovered. Infrastructure, realty and parts of the telecom sector were the worst examples, but there were others. This story is of course, well-known and there's little point repeating it. Like all such stories, it does offer a lesson for the next time around, but that lesson is easy to miss. Some draw the lesson that as the markets get going again, the infra type sectors should be avoided again. Others, more sophisticated investors, conclude that these sectors should be embraced, because, you know, reversion to mean and all that.Either of these could turn out to be correct, it doesn't actually matter.

The more important question to ask is, why did investors choose obviously iffy sectors and invest in them at such high levels of the markets? How did they arrive upon these investment decisions? Was it their own investing psychology, or were they pushed by salesmen of one sort or another? Individually, it's arriving upon the right answer to these questions that will save us from making the same mistakes this time around.

Carefully planned hype and high-pressure salesmanship has played a major role in each such episode on the Indian stock markets. Actually, there's a positive feedback cycle that starts at some point. Some stocks that are part of a theme do well. This gets some attention, especially from those who have interest in other stocks of that theme. Then, the brokers' analysts get into the act of promoting the theme. After that come the overstretched IPOs and follow-on offers.

Something parallel was going on in mutual funds the last two times. There was a flood of new fund offers which followed the same flavour-of-the-day formula for deciding which sectors they would be launched for. They were promoted heavily, and under the rules prevalent at the time, the cost of the promotion came from the investors' pockets.

This positive feedback in favour of bad investment choices was not just for sectors or investment themes, it also happened in case of ULIPs from insurance companies. ULIPs were fantastically lucrative for insurance agents so the salesmanship was more intense than anything else. The markets were doing so well that despite the huge expense deductions, ULIPs still made some money for those who bought into the story. This was all that was needed to provide both the push and the pull for the most damaging investments that most non-investors did.

Even though changed rules mean that the worst excesses in mutual funds and insurance are no longer possible, the general principle stands. When the going gets good, the salesmen get going. All data shows that the individual Indian investors' investing behaviour is self-destructive. The unfortunate part is that there is no end of people trying to make a quick buck out of this. As we enter what could be a long stretch of good times on the markets, investors will have to recognise what is likely to happen, and guard against it.