When a section of the market becomes extremely overvalued and remains persistently overvalued over extended periods of time, what should an investor do? Do you normalise everything and simply continue your SIP in that sector or theme? Or, do you look for other, more conservative options to move your SIP into?
This simple question snowballed into a major controversy last week. The central issue is not about what people want you to buy. The central point ought to be what you are comfortable buying into. Investors must define their comfort zone. An advisor is a conservative-minded thinker and will always want to play safe. Mistaking this approach for risk aversion, lacks adequate understanding. There are times when taking high risks will deliver superior returns. There will always be times when incremental risks deliver adverse results.
It only takes some sense or knowledge to appreciate that we are now in a zone where moderating risks is a priority. When a theme is too overvalued, mechanically investing more stops making sense. Does that mean you should never invest in small caps? The answer is a resounding no. Like fishermen stay away from the seas in rough weather, investors must avoid a space till valuations moderate adequately. When the situation improves, it makes sense to begin investing in that space once again.
But, the investor’s need to chase higher returns makes him reluctant to stop his SIP in small caps. The asset management business is also unwilling to say no to its customers. A sharp contraction in valuations will result in narrower returns for long-term investors and wider losses for recent investors. The problem lies in ownership, who will take responsibility?
Both investors and manufacturers think the other side is responsible. When the situation is so difficult, investors must take ownership and seek the right advice. Especially because markets may become even more volatile. Such advice must be driven by the first principles of safety of capital, avoidance of permanent loss of capital, and moderation of return expectations. Then, the decision to SIP or not to SIP in expensive parts of the market will be simple and obvious.