Rational exuberance

"Taken together, the ingredients I see in confidence-belief, optimism and certainty-combine to create a feeling of well-being, confident investors are sure big returns lie ahead."-Howard Marks
The stock markets have rallied significantly over the last few months. The debt market also has not lagged behind. The euphoric markets have evoked mixed reactions from the investors –existing as well as prospective.
One may deduce that the present volatility is worrisome for most of the investors. More than volatility, what investors fear is the possibility of permanent loss. One can ride out volatility, but undo a permanent loss is much more remote and a loss definitely brings pain and regret.
The stock market functions as a voting machine in the short run; it acts as a weighing machine in the long run. In other words, in the short-run, fear or greed may cause the stock market's price level to deviate significantly from its true value. This should be of no concern to the long term stock investor who knows that these excesses tend to reverse themselves. In the long run, the markets price level will gravitate towards true value.

Be realistic and moderate in future expectations of returns
The present euphoria could bring in an illusion of control to the investors and investors should realise that the window to the future is opaque. "Reality is far more vicious than Russian roulette. One is capable of unwittingly playing Russian roulette - and calling it by some alternative "low risk" game."-NassimNicholas Taleb. The investor should not extrapolate the unprecedented returns over the past few months but maintain equanimity and moderate his expectations for the future.

Extreme market behavior will reverse
Those who believe that the pendulum will move in one direction forever- or reside at an extreme forever-eventually will lose large sums. Those who understand the pendulum's behavior can benefit enormously. The swing back from extreme is usually more rapid- and thus takes much less time-than swing to the extreme. The air goes out of the balloon much faster than it went in.
Graham's definition of investing could not be clearer: "An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return" Investing according to Graham consists equally of three elements:
You must thoroughly analyze a company, and the soundness of its underlying businesses, before you buy the stock;
You must deliberately protect yourself against serious losses;
You must aspire to 'adequate' not extraordinary, performance.
Hence, the focus should be investing in funds which have a consistent performance across cycles of irrational exuberance and unjustified pessimism rather than spectacular performance only during the bullish phase. The focus should be to try to win the investment game by not losing.
Rather than doing the right thing, the investor's main emphasis is not on doing the wrong thing.

Realise the importance of asset allocation and diversification
"Let every man divide his money into three parts, and invest a third inland, a third in business, and a third let him keep in reserve.''Talmud 1200 BC-500 AD.
Life can only be understood backwards, but it must be lived forwards"-This is applicable for investment s also. Only on hindsight one can realise which asset or securities have done well. Asset allocation strategy and diversification are time tested strategies ensure that one is concerned equally with returns as well as risk. The returns of various asset classes over the last few years drive home the point that over various time frames different asset classes perform and one has to be stay invested in each of the asset class to manage risk.
Diversification is a protection against ignorance
It means little sense for those who know what they are doing. Managing this emotional reality is one of the more subjective aspects of risk management through diversification.

Diversification is an admission of not knowing what to do, and our effort will be to strike the average. A single minded focus on return without regard to risk or the converse leads to portfolio selection that is less than optimal. The choice facing an investor, who must decide between seeking high returns and attempting to hold risk at the same time. The solution to the said problem is more complex than linear programming. It is more behavioral.

Plan you play and play your plan
For most investors, the hardest part is not figuring out the optimal investment policy, it is staying committed to sound investment policy through bull and bearish markets and maintaining what Disraeli called "constancy to purpose". Sustaining a long-term focus at market highs or market lows is notoriously difficult. At either market extremes emotions are strongest when current market action appears most demanding of change and the apparent 'facts' seem most compelling. At these points the cost of infidelity to one's own commitments can be very high..
What is required is a systematic approach to investment –Perfect Planning, preparation prevents poor performance. Systematic Investment Plan-diversification of time- preference of multiple bets to single bets-anti panic device-avoids empathy gap and help you invest across various cycles-bearish bullish and range bound.

Do not try to time the market:
The reluctance to acknowledge the role of chance when trying to explain outcomes in the world can actually decrease our ability to predict real-world events. Acknowledging the role of chance in determining outcomes in a domain means that we must accept the fact that our predictions will never be 100% accurate that we will always make some errors in our predictions. But interestingly, acknowledging that our predictions will be less than 100% accurate can actually help us to increase our overall predictive accuracy. It may seem paradoxical, but it is true that we must accept error in order to reduce error.

Focus on long term success rather than on short term profits
Investors begin believing that the test of an investment technique was simply whether it 'worked' if they had beat the market over any period, no matter how dangerous or dumb their tactics, people boasted that they were 'right". The less prudence with which others conduct their affairs the more prudence with which we have to conduct our affairs.
But an intelligent investor has no interest in being temporarily right. To reach one's long term goals one has to be sustainably and reliably right.

Prepare for the eventuality- Have a risk cover
One unique aspect of investor's human capital is mortality risk, the loss of human capital in the unfortunate even of premature death. Life insurance has long been used to hedge against mortality risk. The greater the value of human capital, the more life insurance covers the family demands. The demand for life insurance and the optimal asset allocation have to be decided jointly rather than separately.
To sum up, volatility and risk are part of investment. How to ride over the volatility of market and turn market corrections as friendly and beneficial is the secret of investment success, as every investor is not only concerned about the risk but also interested in the returns.
The nightingale which cannot bear the thorn, it is best that it should never speak of the rose." Aristotle.

R Raja (views expressed are of the author and not of the organisation he belongs to)