In falling markets, consider this for capital preservation and growth

With equity markets tumbling daily along expected lines and margin call-triggered sell-offs, retail traders are undeniably nervous.

A statistical model-based trader like this author can see the nervousness in the market data over the last three weeks. It would appear that some more declines are possible before the markets return back to their winning ways again. Stocks will fall far more than headline indices and retail traders are likely to feel the pinch really hard.

Nuts and bolts of indices

Remember the transistor radios of the 1970s–1980s? We used to carry them around during cricket matches to keep abreast of the cricket scores. They had built-in helical (telescopically collapsible) antennae to facilitate better signal reception. In Indian stock markets, the weightage of the Nifty and Bank Nifty indices is also telescopically designed.

If an index-weighted stock falls in month one, its weightage is reduced in month two. And vice versa. This data is freely available from the website of the National Stock Exchange. That means the indices will always fall less than individual stocks in a weak market and rise more than individual stocks in a strong market.

The other thing to note is the daily range of the indices vis-à-vis individual stocks. If you observe an owner taking his dog for a walk, you will notice the younger pups are friskier than older dogs. They move about a lot with lots of energy. If the owner choses to tie a leash around the dog, he will prefer a longer leash for the pup and a shorter one for the older dog.

Indices are like older dogs. They are a sum of the weighted average of all constituent stocks, which is also telescopically smoothened. Therefore, their intraday price ranges are smaller. In the Indian context, indices tend to move between 1.25% and 1.75% intraday on most trading sessions.

Individual stocks on the other hand move approximately 3.50% intraday on most sessions. That was before 4th June 2024. The statistical ßeta (pure price volatility) has jumped after the election result day. Markets have witnessed steep but brief sell climaxes every month since June. Here they are - 4 June, 23 July, 1-5 August, 5-9 September and 27 September–7 October, 21 October–14 November. The last two declines were prolonged ones this year.

What happened on election results day was mayhem for many stocks. Take BHEL for example – it fluctuated 25% intraday before recovering shortly. One can argue in hindsight that holding the stock would have seen a chance to exit at higher levels later. But how many traders can hold a stock with such margin calls to be met? Take the Nifty in comparison. It gyrated about 8% in comparison. That is one-third of BHEL’s volatility. Nifty was clearly an outperformer compared to many stocks in the following weeks. Remember the telescopic weightage.

The concept of relative out-performance implies that the stronger security falls less than the weaker one in a bearish phase and vice versa.

For more such analysis, read Profit Pulse.

The right instrument

Choosing the best way to invest money in any security ensures a higher probability of success. The best investment is the one which you buy and forget without maintenance expenditure. That rules out index futures because futures entail financing and execution costs. That means lower take home profits. Since indices are artificially created benchmarks, ETFs (exchange traded funds) are the way to go.

They are mutual funds of sorts. Since the fund manager need not shuffle the investment too frequently, these are passively managed funds, with lower fund management fees and transaction costs. That means higher take home profits for the investor.

ETFs invest in the index constituent stocks in exactly the same ratio which makes up the index itself. So, the returns are more or less in lockstep with the index itself. It’s a win-win situation.

Napoleonic logic

French emperor Napoleon Bonaparte deliberately took those army generals on conquering crusades who were known to pilfer the conquered nations’ spoils. His logic was simple. Vested interest of personal enrichment would ensure these generals fought hard to win these wars and fulfil their targets. In financial markets too, it pays to hitch your wagon to the strongest players. They ensure you win with them.

The total investment in Nifty ETFs (exchange-traded funds) is growing rapidly.

The biggest investment by any government body in these ETFs is by the EPFO (employees provident fund organisation) a government of India institution. Their exposure has crossed ₹2.5 trillion, as per Business Standard. 

The average government bureaucrat is sensitive to where his salary is invested and looks after his nest egg carefully. If the EPFO is parking its funds in index ETFs, should you really hesitate? That brings us back to what has been said earlier– nothing happens in financial markets without a reason. And the reason is invariably financial.

Have a profitable day!

Note: We have relied on data from www.nseindia.com and www.business-standard.com throughout this article.

The purpose of this article is only to share interesting charts, data points and thought-provoking opinions. It is NOT a recommendation. If you wish to consider an investment, you are strongly advised to consult your investment advisor. This article is strictly for educative purposes only.

Vijay L. Bhambwani is the author of the first official commodities trading guide in India. He designs statistical and behavioural trading models for his family owned prop trading outfit. He stays at South Mumbai and trades markets since 1986. He tweets at - @vijaybhambwani and has a video blog at www.youtube.com/vijaybhambwani

Disclosure: The writer and his prop trading organisation have no exposure to any index derivatives or ETFs discussed here as per SEBI guidelines.