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Markets continue upward trend in August, but risk management is critical now

Markets have continued to rise this month as well, but ground reality dictates investors should remain cautious and have good risk management in place.

On 1st September 1985, the remains of the Titanic were finally found, 73 years after the tragedy. Why are we starting on this disastrous note? Because the “practically unsinkable” ship offers excellent investing lessons. Risk management is the obvious one. Insufficient lifeboats, patchy understanding of a new wireless system, lookouts without binoculars, and so on.

And yes, one does not simply speed through an iceberg prone area just to break an Atlantic record. But dig a little deeper and systemic reasons emerge. In fact, systems thinking has a perfect model for this. Predictably called the Iceberg Model! It has 4 layers.

The tip is “events” (the Titanic sinking), the next level is “patterns” (increasing disregard for safety systems), followed by “structures” (outdated regulations) and finally “mental models” (greed for profit). Each level offers a deeper understanding of the causation. Sight. Hindsight. Insight. Foresight. Guess another system where it’s applicable - the markets.

1. Take a recent Kodak moment. A few weeks ago, Kodak, now also a drug company (!), got its stock price to go from $2.62 to $33.2 because the Trump administration was thinking of lending it $765 mn. A discerning investor would have seen the pattern, because, in 2018, Kodak had (also) become a blockchain company (!!), and took the market on a similar ride before sinking.

With several pending probes on allegations of wrongdoing, including insider trading, the Trump deal didn’t happen, and the stock is now around $6. A similar penny stocks trend is happening in India too. The RBI governor recently said that the markets are not in sync with the economy. Companies with zero revenue have seen their prices soar. Theatres haven’t even opened, but multiplex stocks are flying high. The Oracle of Omaha said it best, “Be fearful when others are greedy and greedy when others are fearful.”

2. There is inflated expectations, and then there’s inflation. An important component of the market system, and the primary reason for the RBI not providing more rate cuts, since cheap money could further stoke inflation. How does it impact investors?

When inflation expectations rise, interest rates rise, bond yields rise, and bond prices fall. This lowers the returns of long duration debt funds. Whom does it not impact? You, because we recommend only short duration debt funds. 

3. But when it comes to mental models, we recommend patience and a long term view. Think about our economy. The short term view is bleak - even with high liquidity, credit growth is low, and banks seem hesitant to lend money. This means that many businesses are finding it difficult to get capital. The GDP is shrinking and projected to for the next few quarters. Does that mean the long term India growth story is in danger? On the contrary. India is expected to be one of the brightest spots in the global recovery.

The market witnesses events daily. Some investors understand the cyclical patterns of the market across years. A fewer number study regulation, taxation and other structures underlying it, whose impact is spread across decades. And the best investors learn the mental models that drive market (and their own) behaviour, lessons of a lifetime. Lessons bring us to September 5th, Teacher’s Day.

Experience, they say, is the best teacher. Not just ours, but others’ too. Understanding the iceberg model enables us to help you avoid “icebergs”. And yes, to look beneath the surface of the Titanic discovery. It turns out that the search for the Titanic in 1985 was only a cover. The real story was revealed in 2018 - it was a Cold War mission to find the remains of two nuclear-powered submarines that sank in the 60s. While we let that sink in, thank you for reading! 

Indices  and benchmarks in August

Equity

Debt

Indian Mutual Fund Industry as of  July 2020

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