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    Stocks have fallen sharply and so future returns should be good, right? Think again

    Stocks have fallen sharply and so future returns should be good, right? Think again

    Stocks have fallen sharply and so future returns should be good, right? Think again
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    By Ankit Gohel   | Nazim Khan   IST (Updated)

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    Does the recent correction mean that investors should now seriously start deploying capital into stocks?

    Indian markets have fallen more than 20 percent, the defined threshold where stocks are considered as having entered a "bear market".
    Such a steep correction leaves many stocks that look cheap on a valuation basis.
    This means that investors who have capital waiting on the sidelines and enough courage to dip their toes into the market may be well rewarded a few years down the line.
    After all, 'be greedy when others are fearful and fearful when others are greedy,' says the Oracle of Omaha Warren Buffett.
    This point was made by an ICICI Direct report, which pointed out that after markets fall over 25 percent, the future returns of stocks tend to be high.
    As the report points out, there have been six instances in the last two decades where the market corrected more than 25 percent. Out of these, in four instances, the correction was to the tune of 30 percent.
    “A Nifty correction of more than 30 percent offers fresh entry opportunity with one year return more than 30 percent in five of the last six instances in the last two decades,” points out ICICI Direct in its report.
    See the chart below.
    Source: ICICI Direct Research
    Should this mean that investors should now seriously start deploying capital into stocks?
    There's a catch.
    For one, markets fall as much as they want to in a correction, making it difficult to know when they have bottomed out. Pre-defined thresholds such as 25 percent or 30 percent are not the ideal level for investors to start deploying cash.
    Consider the example of the market correction caused by the global financial crisis.
    As the ICICI Direct report points out, between January 2008 and October 2008, the index fell a steep 65 percent.
    What that means is: had investors put money when the market sank 25 percent -- that is when the Sensex fell from 21,000 levels to about 15,750 -- they would have lost another 50 percent before the market bottomed out at about 8,000.
    The other point to be noted is markets do not always go up in a V shape after falling sharply.
    For instance, the market bottomed out in October 2008 before rising a bit and bottoming out again in March 2009. (This was especially true of US stocks where the final bottom was made on March 6, 2009.)
    As a result, even if investors manage to perfectly time the bottom, they may have to wait for a long time before a sustainable recovery finally kicks in -- a period, which could test their nerves to no end.
    The best example of this is outlined in the ICICI Direct report, when the market fell a sharp 53 percent in the 20 months between February 2000 -- the peak of the dotcom bubble -- September 2001, when they finally bottomed out.
    What's worse, stocks spent the next 21 months building a base and going nowhere in particular, before a new bull market could begin.
    This is not to say that investors shouldn't buy shares when the market shows a steep correction.
    As seasoned investors point out, investors should buy shares whenever they see good value emerging.
    But they should do so with the knowledge that such an investment -- coming as it does in the midst of a steep correction -- could continue to fall further for a while before it actually turns around.
    The bottomline: investors shouldn't buy stocks, even if they have fallen steeply, unless they are prepared to take some more loss. They should do so with the full understanding that shares of good companies will turn around sooner or later.
    Or, to quote Buffett again, buy only the stocks you would be happy to hold "if the market shut down for 10 years". To extend the logic further, buy stocks only when you would be happy to hold them if the market shut down for 10 years.
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