Emphasis on stock selection

Suresh Krishnamurthy

EACH year, stock prices decline between October and December, only to rise again the following year.

Sometimes, the fall in prices in the last quarter, or just before it, is considerable, as happened this year. Thus, it stands to reason that investments made in this period could fetch higher returns.

The easiest, and perhaps the least risky, way of taking advantage of this phenomenon is by investing in index funds. Evidently, when one suggests that stock prices fall in the last quarter and rise the following year, the reference is to the movement in the indices. As such, one can invest in an index stock at this time of the year, when prices are at their lows.

Buy and sell: Investing in the index is less risky than investing in specific stocks. However, timing the exit carries its own risks. For the short-term risk-taker, it is important to cash in when the indices touch new peaks. Sometimes, as it happened in February 2000, stock prices rise rapidly over a short period, only to stutter and languish.

In December 1999, when the Sensex ruled at 5005, the mood was upbeat, and the expectation was that the Sensex would cross 6,000 mostly on the back of a boost from tech stocks before end-2000. The index did gallop to 5,933 by February 11. Evidently, the target had been breached and it made sense to sell then.

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Indeed, it is quite easy to reason by hindsight. But how can a retail investor know that the peak has been reached? One parameter that could help is the 52-week high of the indices. If the indices have already reached a 52-week high, it is perhaps time to start booking profits. Investors, again, would be better off gradually liquidating their holdings rather than selling the entire lot in one shot. As one fund manager put it, ``tops and bottoms are for fools,'' and, as such, retail investors could best put their money in, or pull funds out of, stocks or index funds in instalments.

However, booking profits and re-entering at the right time are risky and difficult, even for fund managers, let alone retail investors. Given this backdrop, a strategy of investing when the indices are at their bottoms and holding for a longer term is much less risky. The returns may not be exciting, but would be attractive all the same.

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Active investing: Investing in the index is a less risky than investing in specific stocks. Investing in specific stocks, though, could be more rewarding in terms of returns. For investors willing to bear higher risks and invest in specific stocks, the market movements between April 1999 and October 2000 throw light on such issues as diversification, stock selection and profit-booking.

From April 1999 to October 2000, value stocks were in the ascendant. From October 1999 to February 2000, technology stocks zoomed ahead. From February 2000 onwards, no particular sector gained though individual stocks did. Similarly, from April 1999 to February 2000, MNC stocks had to bite the dust. Technology stocks lost value after February 2000. Most value stocks floundered after October 1999.

These trends suggest that if an investor had a predominant exposure to only one class of stocks, he would almost certainly have suffered. Also, for retail investors who indulge in momentum investing, the price trends indicate the extent of risks involved. For instance, in technology stocks, had one invested in December 1999 or January 2000, instead of October 1999, it is certain that by now all the paper profits would have been converted into modest losses.

These issues are relevant even for the longer-term investor. Since investment timing has such an important bearing on the eventual performance of investments, without diversification, the risks of entering a sector when prices are at their peak and, therefore, suffer from indifferent performance, are only enhanced.

Also, even if investments in a particular sector were properly timed, if stock selection was not up to the mark, the penalty could be equally stiff. These issues do not highlight any new facts. They only underline the importance of picking up stocks wisely and spreading the bets.

Once again, even in direct investing, cashing in on the profits is as important as stock selection and diversification. However, timing one's exit is again not easy. All the same, profit-booking tends to reduce the risks and would eventually prove rewarding. The importance of profit-booking and averaging applies to investments in mutual fund equity schemes also.

Investors would be better off withdrawing a portion of their funds from schemes when stock prices appear to have reached their peak and start investing when stock prices decline significantly. However, if investors feel that they do not have the expertise to time their exits, they should retain holdings longer.