So here we are, in the year 2006, with the Indian stock markets higher than they have ever been, and seemingly, in the middle of a bull-run that emerges stronger every time it falters. At a time like this, it is difficult for an investor to figure out what to do, either with his existing investments or about fresh investments that hed like to make.
In all bull-runs, our instincts suggest that this could go on for a long time. Of course, rational thought suggests that it cannot but then, the sight of the numbers in the pink newspapers marching upward banishes all rational thoughts from investors minds.
The dilemma is self-evident, since we optimistically believe that the bull-run will go on. This suggests that we should hold on to our holdings and banish all thoughts of selling any equity assets. Selling them while the market is rising seems like a stupid thing to do, the equivalent of throwing away ready money that is there to be taken. Sometimes, we think of booking profits, but while stocks are rising, the obvious thing to do is to buy even more equity assets with the profits that we have booked.
And the massive temptation to buy equity assets now, right now, rages unabated. As proof, just look at the kind of money that mutual fund IPOs have collected over the last few months. This is simply unprecedented. Indias investing public has well and truly loosened its purse strings and is lavishing money on equity funds.
While the wisdom, or otherwise, of investing in fresh new funds without a track record is a separate issue, the equity fund IPO boom clearly indicates that investors are unable to resist the temptations of believing that the bull run will continue. This is a mistake.
So will stock prices fall soon No, thats not why we think this is a mistake. Stocks may not fall for years. It is possible that we could be-and weve said this before-at the beginning of a historical uptrend that could see the indices double again in a few months or years. It is also possible that stock prices could either drift downwards or stay level for extended periods of time. As at any other time, any investment strategy that assumes either the continued rise (or fall, for that matter) of the market is doomed to fail.
Interestingly, it is our clear perception that many more investors are following a potentially disastrous bet-everything-on-equity path than were doing so in, say, late 2003. The reason is not far to find. In those days, the memory of disastrous equity performance and great debt performance was fresh in everyones mind. Cast your mind back to August 2003, when the Sensex had risen 30% in the preceding six months and was already at 4,000 points. At the time, income funds recent performance was pretty good. Over the preceding year, a good medium-term income fund would have returned around 11-12%.
Also, investors had sharp, relatively recent memories of the collapse of equities and of superlative performance by income funds. Today, things couldnt be more different. Investors foremost perception is that while equities have gone up from 2,800 to 12,000, income funds have hardly gained and indeed some income funds have even lost money. To be sure, these two things havent happened over the same time frame but the perception is that investing, from now on, is all about equity.
Asset allocation is the key
By any measure, an all-equity investment strategy is not a good way for going about things. Debt is a crucial part of investing. There could be long phases when the stock markets are down. In such times, it is debt that will provide stability to your portfolio. As we have always said, asset allocation is not about some hypothetical measurement of risk tolerance, but about matching the time horizons of your needs to the time horizon of your investments.
If a certain part of your investment is for a short-term, then it must be parked in a short-term instrument, no matter how wonderful you think equity investments are.
One crucial point is that when we say time-horizon, we dont so much mean the total time for which you will need to stay invested as how much notice you will get when you have to liquidate your holdings.
Ideally, (although this ideal is not easy to achieve in practice), if a certain amount may be needed at a days notice, then it must be considered short-term even if that day may not come for an year or two.
Remember, the basic facts of your financial affairs dont change just because the Sensex is at 12,000-and asset allocation is not about the markets, its about you. Therefore, do not let yourself get intoxicated by the numbers. Instead, decide on an asset allocation and stick to it. And thats the key phrase: stick to it.
For the key part of having an asset allocation is to make sure that you must periodically rebalance your portfolio to make sure that you do not stray too far from your targeted asset allocation. Suppose you start out by deciding that 70% of your holdings should be in equity and 30% in debt.
After a year like the last one, it is quite possible that the continuous rise in equity prices could enhance your equity holdings to perhaps 85% of your portfolio. At this point, instead of waiting for them to go up further, you should sell of some equity assets and buy into some debt funds so as to restore the balance to the original 70:30.
If you keep your equity holdings at 85%, any decline in equity prices could hurt you that much more. And this is the key point-you are not only putting your portfolio back in line with what your needs are but you are also booking profits.
The arithmetic of rebalancing inevitably means that you will be selling off that kind of asset in which you have made gains and that means that you will end up booking profits. This will dramatically reduce the risk of losses due to any subsequent fall.
So when do you rebalance There are fundamentally two triggers for rebalancing-time and deviation. You must re-examine your portfolio once every fixed period-which could be a quarter, an year or even longer.
If your actual asset allocation has differed from the ideal one by a certain number of percentage points, then you must restore the balance. Now, by changing the periodicity of this re-examination and by changing the deviation you are looking for, you could make a lot of difference to how much of a headache rebalancing becomes.
In our experience, a relaxed approach is much better. You dont need to look at your portfolio more than once a year and you dont need to bother about deviations smaller than around 5%. While these limits may feel a little too relaxed at first glance, our research has shown that more frequent rebalancing and tighter limits do not actually lead to lower risk or higher gains. Instead they just add to your tax liability.
Which brings us to the question of taxation. Doesnt rebalancing add to your tax liability At first glance, it seems that it inevitably would. After all, the very idea of rebalancing is to sell off holdings that have made profits, isnt it.
Not necessarily. Of course, as things currently stand, long-term equity investments are tax-free but even keeping these aside for the moment, it is possible to rebalance without a tax liability if you are making fresh investments. Basically, if you are investing regularly, you should keep a continuous eye on your investments and make fresh investments in that asset class in which you are running low.
This way, you will find that your investments stay balanced, and in terms of the final impact on your portfolio value, you have achieved the exact financial equivalent of booking profits while paying less, or perhaps no tax.
Some simple arithmetic will show you that your tax liability will get neutralised only if your fresh investments keep pace with the gains you are making. While this is unlikely to happen while the bulls are raging as they now are, it will certainly reduce the tax incidence to the minimum possible.
One implication of this continuous rebalancing may appear to be that you must constantly keep an eye on your portfolio.
At this point, those of you who like to keep their life simple must be wondering if there are any simpler ways of doing all this. Yes, there are and they are called balanced funds. Balanced funds will deliver many of these features in a completely tax-efficient way.
There could be a couple of reasons why investing solely through balanced funds may not work. One is that you cant treat the debt part of your funds holdings as a separately liquid part of your investment.
This means that if your reason for keeping 30% of your holdings in debt was that you may need to liquidate them at a short notice, then that is not possible in a balanced fund. For such convenience, you will need to keep the 30% in a pure-debt fund and do the rebalancing yourself. The bottomline is that no matter how you do it, do not let the markets frenzy lure you into ignoring the basic ideas of asset allocation and careful rebalancing. When the frenzy dies out, you will be much better off by having kept your cool and kept your balance.
The author is with Value Research