How Financial Knowledge Can Assist You to Identify Red Flags in Your Investments?

December 3, 2021 Mutual Fund

The Indian equity markets have tumbled over the past few days, following the detection of a new variant of the COVID-19 virus that is spreading its waves across the globe. The new ‘Omicron’ variant of the virus, classified as ‘variant of concern’ and ‘high-risk’ by the World Health Organisation (WHO) was first discovered in South Africa and now has been detected in different parts of the world.

Due to emergence of the new Omicron variant, the market may witness intensified volatility. While some of the global equity markets witnessed a sharp fall, the domestic benchmark indices i.e. the S&P BSE Sensex and the Nifty 50 have dropped significantly from their all-time highs. Market experts have raised concerns of sporadic lockdowns and mobility restrictions across the economies. Any hasty decision taken by the government to prevent the spread of new COVID-19 variant could ultimately disrupt the economic recovery.

Currently, it’s unclear how harmful the ‘Omicron’ variant is compared to the delta variant of coronavirus. However, if the variant spreads rapidly over the coming weeks or months, it could potentially affect the market and impact performance of various market linked investment avenues.

Does this mean it’s time to be concerned about your investments? Here’s what you need to know…

Recently, I received a call from my friend Rashi after hearing the news about the ‘Omicron’ variant. Rashi said, “Mitali, I just came across the news of a new variant which may once again impose lockdown restrictions and markets may suffer a downside. I need to know if this will affect my investments and what should I do to prevent my investment portfolio from any losses.”

To which I responded, “Rashi, the market has been through a slump in recent days, though it’s unclear how much of that is due to the discovery of ‘Omicron’ variant. It is too early to predict how the new COVID-19 variant may affect the market and your investment performance, as there is not enough information available at present.”

“However, when it comes to your investments you should focus on identifying any red flags in your investment portfolio to prevent it from suffering a huge loss. Some investments carry warning signs, and those who pay heed to such warnings before they could affect their investments have a much better chance of avoiding losses.”

Rashi replied, “Could you explain me how can I identify these red flags and safeguard my investments from any future loss.”

COVID-19 had wreaked havoc on the economy, and during the early stages of the pandemic in 2020, the stock market saw one of its steepest declines in history. Consequently, the new ‘Omicron’ variant of the virus has raised concerns amongst investors regarding their investments in several financial products.

Do keep in mind that the market reacts to countless factors at any given moment and there are several issues besides Omicron that could affect the market conditions. Thus, it is prudent that you should focus on holding worthy investments in your portfolio and timely identify any red flags in your investments.

It could take years for a portfolio to recover from major loss if you continue holding on to poor investments that could have been switched, redeemed or avoided at first place. Even if you get your market timing right on most of your investments, a few bad apples in your basket can spoil the performance.

Fortunately, there are several investment-warning signs and red flags that can help you spot the investment avenues and mutual fund schemes you should avoid.

Let us take a look at some of the most common red flags that could help you prevent any loss in your investment portfolio:

1. Underperforming Mutual Funds

If your mutual funds are underperforming over a long period of time, then it is a point of concern. During unfavourable market conditions, many mutual funds go through the phase of underperformance and later recover the loss when the markets bounce back. For instance, after the March 2020 lows various mutual fund schemes were underperforming, however when the markets recovered by the end of 2020 the schemes managed to recover the losses.

Thus, you must look after the investments in your portfolio that have been underperforming even in favourable market conditions and over a longer time period.

2. Quantitative and Qualitative Parameters

While investing in mutual funds you may check the past performance of a scheme with historical data, however that is not sufficient to consider the scheme suitable for your investment. You must analyse the qualitative and quantitative parameters of the scheme before investing in it, or your investment strategy could fail.

The qualitative parameters include the track record of the fund house offering the scheme, fund manager’s experience, investment philosophy, etc. The quantitative parameters are all about historical data and comparing fund’s performance to its relative benchmark and peers.

Do note that while the historical performance of mutual fund schemes is just the starting point, understanding the qualitative aspects would help you recognise how a mutual fund scheme is likely to perform in future. Hence, the qualitative and quantitative aspects can act as a warning sign that assist you to make informed investment decisions about the mutual fund schemes you are planning to invest.

3. Ensure Your Risk Tolerance

Your risk tolerance is a reflection of your appetite to stomach the market volatility. You may have invested in various investment avenues considering your suitability based on risk tolerance and investment horizon. However, occurrence of any uncertain event such as the pandemic that affects your financial well-being may change your risk tolerance level.

You must ensure that your risk appetite matches with the level of risk your investment possess. In case of some mutual funds, during unfavourable market scenarios the asset allocation of the scheme may also change. After the changes in allocation of a scheme, if your risk tolerance does not match it is a warning sign that you should switch to a scheme that aligns with your risk appetite.

No matter how good an investment might seem, if you cannot handle the risk, that’s a sign that it is not suitable for you.

4. Align Your Investment Objectives

You may invest your hard-earned money into various financial products to generate significant returns that enhance your wealth creation and help you achieve your envisioned financial goals. You must ensure that your investment objective is aligned with the investment avenue, so that it helps you achieve your financial goals on time.

In case, your investments are not suitable for your financial goals, it will not prove to be a worthy investment and you may not be able to raise the corpus as desired for your financial goals at that particular time.

Before you invest in anything, you should assess what your investment objectives are. However, due to any unforeseen event and change in market conditions your investment might not perform well and may not serve the purpose for you to achieve your financial goals. It could be a red flag that you must address, as there is no point in continuing the investment that no more leads you towards achieving your set financial goals.

You must timely ensure that your investments are aligned with your investment objectives and make well-informed investment decisions.

5. Value Traps

Investors are often tempted to purchase securities when valuation are low or invest in schemes that aim to invest in undervalued stocks in order to benefit when the valuation rises. The idea of investing is to “buy low, sell high”. However, do note that, it is not always beneficial to invest in undervalued markets when the price is too low.

If the valuation of a stock falls to a level below its historic average, there is probably a problem, as it may be a value trap. It may mean that while the stock appears cheap based on past earnings, future earnings will be much lower. There may be potential for a turnaround, but turnarounds are highly speculative and need to be treated with caution.

Just because something is lower in price does not mean it cannot decline further. Very low valuations, particularly under normal market conditions should be viewed as investment warning signs.

The best way to identify any red flags in your investments is to have a periodic review of your investment portfolio. This will help you analyse your investments in a systematic and timely manner, even during an occurrence of any unforeseen event that may affect its performance.

Given that, it is all possible only if you are financial literate and you possess the adequate financial knowledge required to identify the red flags as mentioned above. Financial knowledge empowers you to be aware about various financial concerns owing to the markets that have occurred and would influence the performance of your investments. Financial knowledge will give you the edge to be financial conscious and assist you in making informed investment decisions, which is essential in these current challenging times.

This article first appeared on PersonalFN here