Market Risks & Expiry of Capital Gains Tax Holiday - Return Expectations & Strategies.
Four months after the 416 point bloodbath in the Dow, caused by a huge sell off in the China market, the market correction seems obliterated with the S&P 500 at its highest level since September 2000. Fueled by the stock market boom, and the reduction in capital gains from 35% to 15% in 2001, companies have been declaring handsome dividends, which swelled to a record $418.5 billion last year, up 57% from $266.5 billion 2005. Markets have discounted another rate cut, which does not seem to be imminent now.
Yet, the volatility continues, due to the absence of a significant driver for the bulls in the light of profit diminution, inflation concerns, and announcement of China's economic growth accelerating to 11.1% in the 1st quarter, leading to fears of an overheating economy.
Such dubiety prompts us to inquire, "What would the ideal strategy be going forward?"
No investment outlay is 100% risk free. Investors invest into various asset classes, depending on their appetite for risk, as well as varying return expectations. This is generally termed as the Risk Reward tradeoff, implying the higher the risk, the greater the expected returns from an investment.
In addition to the risk displayed in the short term, an actively managed fund will now impose a huge tax bill reducing the post tax returns in the hands of an investor. These funds have been reaping tax-free returns for 4 years now. This was possible because many funds were bleeding huge losses during the market slide in 2000-2002. Mutual funds hold a provision whereby the losses made on selling losers can be offset against the profits made on selling winners for the purpose of calculating capital gains tax. Further, losses can be carried forward for a period of 7 years. The Fund Managers in their exuberance to best benchmark returns have been making aggressive calls, increasing the turnover of funds to lock in quick profits. Most of these carried forward losses have now either expired, or exhausted. Therefore, the returns will be taxable henceforth.
The strategy, henceforth should be-
A well-diversified portfolio comprising of negatively correlated assets will reduce the Systematic Risks (risks affecting the market as a whole) and Unsystematic Risks (risks affecting individual companies). Investing across various markets, sectors, industries, market capitalization's, and asset classes (bonds, equity) will increase diversification.
Another way to combat risk is to stay invested in the market for a long term, for which market corrections become insignificant. Over a long period, short-term volatility gets smoothed out and temporary losses are erased. This is the rationale for the buy and hold strategy adopted by value funds Vs. actively managed funds.
To reduce tax burden, economists prognosticate that Equity Income Funds, which pay Tax-Advantaged Dividend Income instead of Fully Taxable Interest Income, will aggrandize their presence.
To synopsize, the idea is to be aware of risks and market circumstances, and take timely calls to combat them. After all, as Warren Buffet once said, "Risk comes from not knowing what you're doing ."