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Friday, July 15, 2016

How to avoid buying near a market top and selling near a market bottom

Common sense suggests that investors should buy near a stock market bottom and sell near a stock market top. But time and again, investors do just the opposite. They buy near a market top and sell near a bottom - losing their savings in the process.

Why so? The short answer is: Greed and fear. The greed of making quick money when the market has already gained a lot. The fear of saving whatever little they can of their invested amounts when all gains disappear and the market still keeps falling.

Even for experienced investors, it is very difficult to identify stock market tops and bottoms precisely. The brave-hearts keep trying by utilising various technical indicators that are supposed to identify when a market is in the throes of euphoria and when a market is totally in the grip of doom and gloom.

Smart investors follow an investment strategy that has been honed over the years. Since each individual is different from another - physically and mentally - investment strategies should take these differences into account.

How? By making a plan. In fact, two plans. First, a financial plan that includes current earnings and savings, present and likely future requirements - be it higher studies, marriage, child's education, parents' medical needs, retirement - and last, but not the least, tolerance to risk.

A financial plan acts like a map for the future in money terms - what amounts will be needed at various future life milestones, and what savings and investment instruments (depending on an individual's risk tolerance levels) will help provide the required amounts at those particular milestones.

Sounds complicated? It only requires a little bit of effort and the desire to make that effort. It definitely isn't rocket science. In fact, there are websites that will guide you how to develop a financial plan for free (if you don't want to pay for the services of a professional).

After you prepare a financial plan, it will be time to prepare an asset allocation plan according to your risk tolerance. The assets can be stocks, mutual funds, fixed income instruments, gold, cash. The proportion of your savings allocated to each asset will form your plan.

Real estate is usually kept out of a small investor's asset allocation plan because real estate investment usually means a flat for self occupation, which is unlikely to be sold in a hurry. 

So, what does all this planning have to do with avoiding buying at a market top and selling near a market bottom? 

Everything. Once you start following your plan, it will 'tell' you when to buy and sell which asset. Think about it. If the market shoots up, the 'stock' portion or 'equity fund' portion of your assets will increase in value. Proportionately, your investments in fixed income, gold, debt funds will reduce in percentage terms.

Beyond a threshold, which you can preset, it will trigger a 'sell' in stocks and 'buy' in other assets - to keep the percentage allocations to each asset class intact. So, you will actually sell near a market top.

The reverse will happen when a stock market starts sliding fast. Beyond your preset threshold, 'stocks' will become a 'buy' and your other assets will become a 'sell'. So, you will buy near a market bottom. 

This periodic adjustment in your asset allocation plan according to market conditions will keep your original percentage allocations intact - and free you from the clutches of greed and fear at market tops and bottoms.

Read more about it in this article from investopedia.com.

Related Posts
How to reallocate your assets
About Asset Allocation – a guest post

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