Six sigma has been made famous by the dabbawaalas of Mumbai, but for investors, it means days when the market drops as if its bottom has fallen off. All investors dread those days — and there have been enough of those in the current rally — such as the period after the general elections in May ’04, the correction of May ’06 and the more recent (and milder) one in February.

Things would be a lot simpler without six sigma events, which trigger sharp and unexpected market fluctuations, but since they have become a part of life, we can at least attempt to minimise the ensuing damage. ET Intelligence Group has tried to work out a strategy for retail investors to minimise the disruption caused by sharp market fluctuations.

While these extreme fluctuations cannot be predicted, it is seen they often follow close together. This has happened five times since ’00. On four of these occasions, the market witnessed corrections ranging from 11-15% in the month following the second event. In the fifth case, the correction was on a much smaller scale.

For instance, take the market correction of May ’06. On May 15, the Nifty fell by a little over 4% — more than three times the standard deviation. Two days later, the stock market gained 3.2%, which was high, but not exactly where it should have been. On May 18, the market tanked 6.77% — an extreme event which triggered the massive fall witnessed in the market subsequently. The Nifty dropped around 15% over the next month.

However, just because the market behaved in a certain manner in the past doesn’t mean the pattern will recur. Also, there is no guarantee that these events will continue to happen with any regularity — that’s a call the investor has to take. We have tried to identify some possible courses of action for an investor based on this premise.

Unlike the passive strategy of ‘buying for the long term’, these require the investor to track the market and act accordingly. We suggest that you liquidate your portfolio on the day of the second fall and re-enter after a month — either in index funds or in the stocks that have fallen the most. Keep part of holdings in cash and go short on the market after the second fall.

The risk-averse

Two sharp movements in quick succession may indicate a market correction. Recent market movements show that these corrections came in the form of a few sharp falls, rather than gradual declines.

Risk-averse investors can liquidate their holdings on the day of the second movement, or immediately afterwards. Hang on to cash for a month — that seems to be the worst period — and then invest again. The re-investment can either be in an index fund or in the stocks that have fallen more than the index.

During the May ’06 correction, stocks of companies such as Oriental Bank of Commerce, Jet Airways and ONGC fell by 25-30% after the second day, against an index fall of 15%. The cornerstone of this strategy is to stay out of the market during the correction.

The stocks that suffered the sharpest falls during the earlier market corrections are identified in the table below. The downside here is limited. But you may miss out on the upside if instead of tanking, the market goes up.

The risk-taker

The second extreme event indicates that the stock market is in the correction mode. Liquidate your holdings and if you feel adventurous, you could even short Nifty and exit after a month. Shorting the index after two sharp falls may seem counter-intuitive, but in the past, this has indicated a market correction. This is inherently riskier than the other approach because your downside isn’t limited and you can lose your shirt, literally.