The Hindu Business Line : Who shouldn’t invest in stocks

Stock market investing has turned out to be much more risky than most of us thought. The bull market that lasted till end-2007 had its moorings in strong earnings growth from India Inc.

There was no coterie of operators who rigged up stock prices at will, as they did in the bull market of 1992. Nor was it like the dotcom boom, where a handful of stocks rose up to three-digit PEs, based on fanciful notions of a new world order!

The broad sweep of the recent bull-run and rising institutional interest in the Indian markets had led everyone to believe that this time was, indeed, different.

Yet, the 2008 market meltdown, which wiped out 70 per cent of India’s market cap and pulled down the Nifty by 57 per cent till date, is the worst one in recent memory, even exceeding the dotcom crash. For first-time investors in stocks, this may be a great time to invest. But let’s use this opportunity to reiterate who should not be investing in the stock market. Even today.

Ability to handle losses

Raghuraman, 60, retired in 2006, has been a regular investor in equity funds over the past three years.

Not only has he parked a good portion of his gratuity and retirement receipts in equity funds, he has also continued to invest in systematic investment plans since.

“Dividends from equity funds are tax-free and they deliver a much higher return than fixed deposits,” he points out. In any case, the returns, if any, generated by his retirement kitty are “surpluses,” as he receives a healthy pension from his ex- employer to meet his living expenses. Well, with the equity funds he owns suffering a 50 per cent erosion since January, the investment gains made till end 2007 have been wiped out. Nor are the equity funds in his portfolio likely to pay dividends over the next couple of years, as they have no capital gains from which to distribute dividends.

That may not leave Mr Raghuraman short of cash to meet his living expenses. But with inflation ballooning and his retirement kitty depleted, would he have a sufficient cushion to meet any emergency expense?

Lesson: Decisions to invest in equity should, first and foremost, factor in the prospect of downside risk.

If your capital is at risk, would you still choose to have a 100 per cent allocation to equity, just because the returns (if any) would be tax-free? Investors with a limited ability to take losses should avoid stocks, or at best, limit their stock market investments to say, 10 per cent of their overall savings.

Not for the highly leveraged

The Mitras, a young working couple, earn a combined monthly income of Rs 60,000. Of this, Rs 20,000 goes towards paying the monthly instalment for their home loan and about Rs 10,000 a month towards paying off credit card bills.

After setting aside monthly living expenses of about Rs 20,000, they plough Rs 10,000 a month into equity funds, in the form of SIPs.

While their bank balances are negligible, almost their entire savings are parked in equity funds. “We are young enough to have the risk appetite for equities”, they explain.

But the Mitras’ investments haven’t worked out as planned. Rising interest rates have recently enhanced their home loan EMIs from Rs 20,000 to Rs 23,000 while big-ticket purchases have made credit card bills balloon to around Rs 15,000, leaving much less than before for living expenses and investments.

Pre-paying part of the home loan by drawing down investments seems impossible now; as the Rs 3 lakh investment in equity funds has dwindled to Rs 2 lakh making it a bad time to exit.

Lesson: Equities should be a parking ground only for surpluses, after putting away sufficient funds in safer investment options.

A term insurance policy, an emergency fund in the bank to meet six months’ living expenses and investments in fixed and term deposits, should all precede allocations to equity.

Investors with significant debt obligations should tread all the more cautiously with stocks, as they may have little flexibility in their spending patterns to handle difficult times.

Not for short-term goals

Comfortably placed on his other investments, Mr Mehra’s key financial goal is his daughter’s wedding, likely in 2009. Estimating that the wedding would cost Rs 10 lakh, he had been regularly buying stocks since 2003.

By end of last year, his investments were ahead of the target and were worth Rs 12 lakh. But with the market crash wreaking extensive damage on the portfolio, it is now worth Rs 5 lakh. Withdrawing now would leave Mr Mehra Rs 5 lakh short of his goal; but waiting is not an option.

Lesson: The suddenness and the depth of the recent correction underlines that equity market reversals are impossible to predict.

And you can never bet on corrections stopping just at 10-15 per cent. Therefore, counting on equity investments to finance obligations that are likely to crop up over the next 1-3 years, is fraught with risk.

If you are building capital towards a financial goal, make sure that stocks are a large part of the portfolio only if you have a minimum five-year window.

Even with longer-term investments, the two years preceding your goal should be devoted to liquidating stock market investments in phases and switching into debt options, so that a sudden reversal doesn’t leave you short of target.

Also, when it comes to the stock market, it pays to quit when you are ahead. If your investment has already delivered your target returns, book profits. This may mean foregoing a good portion of further upside, but may leave you in a better position to meet your goals.

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