The Hindu Business Line : Time-diversification can minimise Catch-22 risk

“… . Orr would be crazy to fly more missions and sane if he didn’t, but if he was sane he had to fly them. If he flew them he was crazy and didn’t have to; but if he didn’t want to he was sane and had to.”

– Joseph Heller, in Catch 22

Yossarian, Heller’s hero in the book, is not the only one facing a Catch-22 situation. All investors are suffering from it due to the current stock price movements. The S&P CNX Nifty and the CNX Mid-cap Index have risen 55 per cent and 75 per cent respectively in one year.

Such a sharp climb in stock prices has left investors worried. Would it be prudent to move into cash before market reverses sharply? What if prices continue to move up instead? Investors will then be missing out on a sizable upside potential. But if investors continue to have exposure to the market to capture the upside potential and the market turns down, their losses will be very high. That is the Catch-22 situation.

This article gives suggestions on how to minimise the Catch-22 risk. This is the portfolio risk due to choosing one of the two states — staying invested or reducing exposure. This risk comes from a trade-off between fear and greed. Fear will keep investors away from the market while greed will pull them towards it.

Stock prices are currently stretched based on valuation models. While market moves on perceptions of fundamentals, it does revert to its mean over time. This calls for a delicate balance between riding the uptrend and not exposing too much capital to downside risk. Time diversification and strict money-management rules could reduce the Catch-22 risk.

Catch-22 risk

Trading strategies are typically negatively skewed. That is, strategies generate small gains most of times but large losses sometimes. Such trading strategies are a function of human behaviour. We prefer to take profits too soon but sit out losses for a longer time. What if the infrequent large losses occur now? Nicholas Taleb narrates the story of a turkey to capture the event.

A turkey is fed for 1,000 days in a row. The turkey has a sense of well-being until Thanksgiving. On that dreadful day, the bird rests on the dining table. A “Black Swan” event is one which is hard to predict — the turkey did not know it was going to be dinner on Thanksgiving. Neither do investors know when the market is likely to turn.

But staying away from the market now for the fear of Black Swan event could well mean losing out on the upside potential. The problem is that investors always predict a market peak ex-post (after the event), not ex-ante. An optimal solution would be to ride the uptrend but not expose too much capital to downside risk. How can that be done?

Time diversification can minimise the Catch-22 risk. This refers to allocating assets through various time horizons so that the portfolio is exposed to price movements across time.

First, it would be prudent to reduce exposure to stocks that have generated more than 100 per cent returns. Suppose you hold 1,000 shares of Essar Oil bought at Rs 80. You should sell 250 shares at Rs 325 to recover your capital first. Then, sell another 250 shares at a higher price to capture some profits. The balance of your holding is free.

On this portion, you can ride the uptrend until you want to. Importantly, a downturn in price will not hurt you as much! Then, sell 50 per cent of holdings in stocks that have generated less than 100 per cent returns. Decide whether you want to hold the rest for another year. If not, take profits at a higher price but manage the positions with trailing stop-losses.

Importantly:

Allocate 20 per cent of your total assets for short-term trades. That way, you will not feel left out if the market continues to trend up. Increase fresh exposure to this ‘trading portfolio’ beyond 20 per cent of your total assets only if you want such stocks to be part of your core holdings.

Have no more than 40 per cent of the total assets as core holdings. Trade 10 per cent of the core holdings in the short term if you want to. You can buy back these shares at a lower price after the market turns down.

Practise strict stop-loss rules to minimise losses on short-term trades. Asset allocation policy will be 40 per cent core holdings, 20 per cent short-term trades and 40 per cent cash equivalents. Cash can be used to buy shares after the market turns.

And remember this, if nothing else. Do not day-trade if it does not suit your personality. How will you know? It doesn’t suit you if your heart starts palpitating faster after you place the trade.

(The author is a Chennai-based investment strategist. He can be reached at enhancek@gmail.com )

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