A balanced approach to investments will place you in a better option to achieve your financial goals
Here are two common responses to stock market moves" Markets have been zooming up for the past three months. I must ramp up my equity holding by moving out of my fixed deposit otherwise I will miss the bus" and "Market are crashing rapidly. I must bail out of equities and shift to fixed deposits before I suffer even more losses".
The sad fact is that one ever knows the prospective returns that an asset class will give in advance and the precise timing of those returns. Worse, attempts to make up for our lack of foresight by plunging headlong into outperforming asset can have disastrous consequences for one's financial health as more often than not we do so at precisely the wrong time i.e. AFTER we have noticed that the asset has run up.
There have been a number of studies / reports depicting returns given by various asset classes over the years. Rather unsurprisingly, there was no one single top performer over different time periods.
I believe that the only way to avoid getting whipsawed is to maintain a constant asset allocation. By doing so we will protect ourselves from the psychological and financial ill-effect of "performance chasing".
Here are a few ways to go about it
- Follow a thumb rule stated by John Bogle of Vanguard that the amount of equity owned by you should be 80-your age. Hence if you are 30 years you should have 50 percent in equity. Of course, being a thumb rule, it must be used in conjunction with other factors.
- Get a grip on the amount of volatility you can endure and adjust your equity component accordingly. Equities as a whole are more volatile than debt instruments but purchasing equities when valuations are low is actually LESS risky than moving into bonds at the wrong time. However your comfort level to equity will depend on your psychological make-up and financial situation, both of which will be independent of the prevailing market index levels.
- Maintain a sense of balance : Your portfolio should include assets which will meet your liquidity as well as growth requirements. Too much of one over another is not advisable. While you should rely on equities to meet your longer term goals (those beyond five years), fixed deposit and short-term debt fund are more suitable for shorter time horizons. Alternative asset classes such as precious metals, real estate, private equity etc. protect you against inflation and also provide returns which are usually less correlated to mainstream investment classes such as equity and debt albeit, at the cost of liquidity.
- Use the right vehicle: Determining the desired balance between different asset classes is only part of the game. This must be followed by honing in on the right vehicle within the asset class. For instance, within fixed income would you prefer fixed deposits, debt funds, bonds or loans. Or within equities, would you prefer investing directly in equities or opt for the diversified equity mutual fund route. For gold, would you prefer buying Sovereign Gold Bonds, gold coins, units of Gold ETFs etc.
Besides these, ensure that:
- You re-balance periodically: Movements in market prices will lead to passive changes in your asset allocation even though you may not actively alter it. For instance if your stocks move up by an average of 20% in one year (without any change in the valuation of your debt investments), your original equity : debt balance of 60:40 will automatically change to 72:28. Hence it is prudent to revisit once a year or so in order to restore it to its original balance. Of course, when one class is rising fast, it is mentally difficult to book profits as we would fear an opportunity loss but you must be resolute.
- You do not ignore the Tax angle: Every time you re-balance, you may be liable to pay Capital Gains Tax on the same. Hence rebalancing too frequently is not advisable. Beside the very aim of asset allocation is to obviate the hazards involved in market timing and predictions and this is defeated when we keep a constant on the markets with the aim of re-balancing.
To conclude, as in everything else in life, a balanced approach to investments will place you in a better position to achieve your financial goals as well as in ensuring peace of mind.
Views of the author are personal