Friday, August 19, 2011

Investor Type

Your investment style will not only determine how you behave during a market crisis, but also help you take the right decisions.

Uncertainty, which breeds fear of the unknown, hinders an investor's ability to make rational decisions. When the markets are buffeted by negative news from around the world and the general consensus is that the worst isn't over, investors become confused about the course of action they should take. The overload of information and analysis makes things tougher. Ultimately, how he behaves during a crisis will depend on the kind of investor he is. The investors who are financially weak may not be able to participate in every kind of market and should know when to keep out. So, risky markets are not for a person who is, say, rolling over his credit card dues, or is paying a large EMI for house that is yet to be delivered, or is worried about not earning or saving enough. The investors who have a limited corpus or significant liabilities, and senior citizens with a low risk appetite are better off not taking drastic measures in risky markets else they can loose much more than they can afford.

Strategic investors, on the other hand, focus on building long-term wealth. They are smug in the knowledge that 10 years on, the events that seem cataclysmic now will be pale into insignificance. They stick to an allocation pattern - say. 50% in equity, 30% in long-term debt, 10% in short-term debt, and 10% in gold -- and earn reasonable returns across market cycles. Sticking to one's allocation means continuing to invest in equity even as the market falls and keeping money aside in debt even if the equity market rises. A strategic investor does not care much for market cycles. Instead, he has faith in the power of  time to even out losses. For such an investor, panic-driven crashes in the market are opportunities to reduce the average cost and even out the expensive pricing of the preceding boom. The losses during the downside are taken in stride as an essential biter pill in order to be present in the market when it turns up. This breed does not use borrowed capital, and is not in a hurry.

Tactical investors are the ones who are tested the most during any uncertainty. This breed lies to predict how asset classes are likely to perform, and based on the macro picture that emerges, it tries to modify the portfolio to protect it from losses. For instance, a tactical investor would reduce his exposure to equity if he foresaw any risk to global flows. He would also increase the exposure to gold in an attempt to cash in on the clamour for a safe investment in turbulent times. In the face of an expected drop in a global demand, this group would reduce the exposure to commodities. or would avoid long-term debt if a jump in market and credit risk was on the cards. Obviously, not all calls can be accurate. Tactical investing needs expertise and skill in reading the market signals, as well as the ability to reallocate assets. The investors who see themselves falling short in either department should keep away.

Some investors enjoy event-based trading. Here, the temptation to buy an asset that is moving up is high. This group uses available information, even if it's partial, for a quick take on an event before making a move, hoping to make money from the resulting volatility. Such investors should focus on the capital in hand and be willing to book losses if their call goes wrong. The amount they allocate to an asset after reading the signs should not be too large a component of their wealth, as it can wipe them off. 

There are bound to be problems if the investor's behaviour in uncertain times does not match his type. So a strategic investors gives in to panic and quits the market in haste; an event-based trader stakes a large chunk of his portfolio in what everyone is chasing but fails to exit in time; a tactical investor assumes that all his calls will hit the bull's eye and borrows funds to add to a position he holds, making a risky bet riskier;  a financially weak investors hopes to make good an earlier loss but ends up repeating his mistakes.

Hence, it is crucial to identify the type of investor you are, to think through your action plan and focus on your wealth before you act on the market information.

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