Recently, social media has been inundated with inquiries from people seeking advice on how to position themselves in anticipation of significant events, such as trends emerging from the general election at 9.15am on 4 June, when India’s equity markets open for trade.
Big events often create anxiety for most people regarding the decision to act or not. This response is quite natural and is part of human evolution. Uncertainties, especially unfavorable ones, were historically addressed by the fight-or-flight response. For example, primitive humans living in jungles relied on their senses to survive in a hostile environment. So, when faced with a rustle in the bushes, their minds would enter hyper mode, first estimating whether it was a tiger or a rabbit behind the bush, and then deciding whether to flee or stay put.
Investors are also humans, and their brains have evolved in similar aspects to other facets of their lives. This extends to their investment journey as well. When faced with a planned event like general election results or an unplanned event like a war, their minds enter a state of hyperaction, attempting to predict the outcome and leverage it to their advantage or for survival to fight another day.
For an event like the general election results, both incumbents and opponents build narratives through moves and countermoves. These narratives create confusion, which then leads to uncertainty in the minds of market participants. They, in turn, start assigning probabilities to outcomes—incumbent win, opposition win or a hung parliament. Depending on how one was positioned regarding market direction, they either take comfort in these probable outcomes or become perturbed by events not unfolding as desired.
Acting on whims is not advisable, especially in equities, as it could lead to actions that are not easily reversible. So, let’s consider what one can do to navigate such events instead of worrying or becoming ecstatic about them. When faced with such a situation, one is always advised to control what’s in their hands by reverting to two principles of personal finance—reducing risk and maintaining liquidity.
Risk reduction can be achieved through diversification, defensive asset allocation and hedging. Diversification assists in mitigating unsystematic or non-market risks, which are specific to a company, sector, country or asset class. By spreading investments across a wide range of assets, one can potentially minimize the impact of adverse market movements on their overall portfolio. However, even after sufficient diversification, a residual risk remains—primarily systematic or market risk—which cannot be eliminated but can be mitigated through additional measures. Nevertheless, one must accept and manage this risk, whether they prefer it or not.
One could also include defensive assets in their portfolio, such as debt, cash or precious metals like gold that have exhibited lower volatility during market turmoil. These assets can serve as a hedge against downturns and provide stability to the portfolio. However, this comes at a cost. As the saying goes: ‘A ship in harbor is safe, but that is not what a ship is for.’ Therefore, one could miss out on potential gains if they take a defensive position and the markets rally from that point onward. Thus, one should tread carefully before adopting such a position.
Hedging is another way one could protect their portfolio from downside risks. Futures and options contracts are common hedging instruments that can be used to offset losses in your portfolio during market downturns. But, again, there are no free lunches in the market, and it also comes with hedging costs. So, unless one is nimble and prepared to accept that the trade might not go their way, one should not be adventurous and avoid such a strategy. Thus, reducing risk by these measures works up to a limit and could not be eliminated.
So, what else could one do apart from this to manage such big events? Let’s examine the purpose of investment. The purpose of an investment is to delay consumption now by allocating funds so that they can generate income or appreciate in the future. One should always be mindful of maintaining liquidity to meet financial commitments. There is no point in investing in an asset class and then continually monitoring its day-to-day performance. A better strategy would be to assess one’s liquidity needs for important goals in the next few years and then reallocate funds from volatile assets like equities to less volatile assets like debt. This reallocation should occur regardless of any significant events that may impact the portfolio.
Finally, remember that politicians aim to win elections, so they often make promises that appease their supporters and attract fence-sitters by offering grandiose pledges. However, they are also aware that harming the economy ultimately goes against their self-interest. Therefore, once in power, they are unlikely to take actions that could jeopardize their chances of re-election. So, there’s no need to lose sleep over or be swayed by public opinion on the outcome of an election. As James Carville, strategist to former US president Bill Clinton, famously noted during the 1992 US election campaign, ‘It’s the economy, stupid.’
Abhishek Kumar is a registered investment advisor and founder of Sahaj Money.