Investors love rising equity markets. The last 18 months have seen stock markets go through a dream run with massive amount of wealth creation. This is not the first bull cycle where markets have rallied with such depth of participation and momentum.
Equities are now a TINA factor and the rush to invest is evident in the last few months when mutual fund flows have been the highest ever. Flows into domestic mutual funds combined with ULIPs are expected to touch more than $25 billion in the next few years. Positive news flow in the mainstream media, commentary/interviews with experts, professional investors, expectations of economic recovery and rear view bias are now influencing investors to ramp up their asset allocation to equity and fast.
Though not new, the tendency to invest based on recent performance is a common behavioural bias and is difficult to overcome for many investors as they believe that future returns are predictable while they actually are not. If you look at the history of stock market returns, performance chasing investing is almost certain to produce disappointing results. Investor returns for the immediate years following a bull market cycle have been marginal to negative in almost all cases.
While there is no getting around this, one way to mitigate would be to analyse economic data, trends and determine the probable outcomes. This is out of reach for a common investor and best left to professional money managers.
Risks of improper equity allocation
Let’s look at what probably happens when you increase allocation in rising equity markets. Firstly, it tinkers with your asset allocation as inappropriate allocation tends to affect long-term returns. Secondly, most investors will eventually exit at the bottom of the cycle when conditions change. This is reflected from negative flows in mutual funds when equity markets are going though a bad phase.
While these tend to be the best periods to invest, investors tend to do exactly the opposite of what they should be doing. Low confidence and aversion to losses result in exits at the wrong time and thereby destroying the long-term compounding opportunities coupled with sub-optimal returns. Subjectivity scores over objectivity comprehensively, and ultimately less than 5% of equity investors tend to be contrarian, disciplined in this phase and hence are vastly more successful than the other 95%. Markets are always smarter and ahead of time.
Thirdly, the most important risk in this phase would be the absolute risk that investors would be taking. Downside risk is a measure of the indicative fall in value if the market conditions change and indicates the worst case scenario. Over the last 2-3 years, the rally in small and mid cap stocks has been extremely sharp and investors are happily ramping up exposure to this space unmindful of the associated risks. Unless invested thoughtfully, in all probability, investors would be staring at sub-par returns as margin of safety is the lowest in this segment of the market now.
The steeper the market climb, the fall is likely to be equally steeper. If you look at data for the last 20 years, the market fall from the top of a cycle until the bottom tend to be steep and sharp. In the last market crash in 2008, frontline indices fell 65% from the top before markets bottomed out. The fall in the mid and small cap indices was much steeper. Investors who have navigated this tough phase have emerged successful while a number of them got out near the bottom and never got back in.
Investors need to be cautious now and understand that long-term sustainable wealth creation comes from having a focused and disciplined asset allocation framework in place. A sensible strategy is to build a diversified equity portfolio that matches their risk tolerance and temperament.
Understanding absolute risk will help avoid any self-inflicting wounds from excess equity allocation beyond one’s risk taking ability. Periodic rebalancing without forecasting would go a long way in adapting to volatility and compounding their portfolio.
The author is co-founder and director, Entrust Family Office Investment Advisors