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Market trends: straight lines or circles?

If you forget that market trends are not straight lines but circles, then you could be giving yourself a needlessly hard time


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Over the last one year, it's been hard to talk to an equity analyst or trader without getting an earful about the poor performance of mid- and small-cap stocks. Over this period, the Sensex has pulled up by about 12 per cent, while the mid-cap index has declined by about a per cent or so and the small-cap index has declined by about 5 per cent.

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As always, the universe of mid cap and small companies is much more diverse, which adds to the complaints. Among the constituents of the BSE Midcap index, there are eight companies that have returns of more than 40 per cent for the year, while at the bottom, there are eight that have declined by more than 40 per cent. While this symmetry is a coincidence, the general shape of returns is not. The smallcap index also has almost as much diversity of returns. The same principle applies to mutual funds, although the extremes of returns are obviously not there because the fund managers (mostly) eliminate that.

Even so, there's a certain pointlessness to this complaining about midcaps and smallcaps. The reason is that if instead of looking at one year, investors look at longer periods like five or ten years, then the picture becomes much smoother. Over the last 10 years, the Sensex had a rate of return of 10.34 per cent annualised, the midcap index of 11.15 per cent, and the small cap index of 9.42 percent. The total accumulated increases are 2.7X, 2.9X and 2.5X, which means that there's hardly anything to choose. Over such a long period, these returns are identical for all practical purposes.

Of course, during the intervening years there were many periods when this symmetry was invisible. One or the other type of stock was racing ahead, while others were lagging. However, a reasoned look at the history of equity prices always shows that there are cycles of different types of stocks doing relatively well or relatively badly. Over time, as one goes through a complete set of cycles, the returns even out.

More important is the conclusion that one can draw about investors' current behaviour. Far too many people think that every trend that is currently extant is extendable into the future, as far as one can imagine. If mid caps and small caps are doing badly, then they must continue doing badly, going from bad to worse. In the past - very recent past - there were plenty of investors who thought the same of large caps. They would invent complex reasons - delivered with great finality - as to why the Indian large-cap story is over.

However, all that is needed is experience and a memory of all the previous times when current trends seemed so strong, but when the cycle turned around, they all disappeared. This constant awareness of the fact that nothing is permanent and that everything comes around is what distinguishes experienced investors from those who have merely spent time in the markets.

So what really matters is not the market cycle itself but what I'd call the psychological cycle of investors. As the market goes through different phases of its cycle, your mental state also goes through certain phases in response. In the end, whether you make money or not and whether you meet your life's financial goals depends on what the stages of your personal psychological cycle are and how you manage them.

These psychological cycles can be understood as a sequence of mental states. Starting from a point when the market just starts rising from a previous low, this sequence could be something like this: Optimism, Enthusiasm, Exuberance, Euphoria, Anxiety, Denial, Fear, Despair, Panic, Discouragement, Dismay, Hope, Relief, and then back to Optimism. It's quite obvious what stage of the market maps to which emotion.

This cycle is reasonably well-known and if you go googling, you'll find a lot of posters and memes about it. You'll also find a great deal of gyan on what are the best points on the cycle to invest. Typically, the diagrams will mark the 'Euphoria' stage as the point when greed is the highest and this is the worst time to buy. Similarly, the 'Dismay' stage is generally pointed out as the best time to invest.

This is obvious, and like many obvious things about investing, it's pretty much useless. The reason is that all this makes sense only in hindsight. Things look very different when you are living through them. At the end, you learn your lesson about sticking to quality investments, and then when the cycle begins again, you're fine. Instead of that laundry list of ever-changing emotions, you have just one or two emotions, which stay with you permanently. These are watchfulness, and quiet confidence. At that point, the cycle does not matter, you've banished it from your investment experience.

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