Equity investing is safe: just follow the rules

Equity investing is safe: just follow the rules
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First Published: Wed, Mar 18 2009. 01 15 AM IST

Updated: Wed, Mar 18 2009. 11 50 AM IST
Everybody knows that roads are unsafe, people get run over and cars smash into each other. Yet we continue driving, riding, walking and crossing these roads because there’s a set of rules that defines road use and works 90% of the time.
Equity investing is no different. There is a set of rules out there that allow long-term wealth creation. But you’ve got to look at both sides of the road before crossing it.
The first two rules of investing are: invest regularly and make an asset allocation. The first gets us to make a saving target and puts money away in a financial product other than a savings deposit each month.
The second wants us to split that money into two buckets—debt and equity—and stick to that allocation unless our view on our risk-taking capacity or personal situation changes.
The debt bucket is full of provident fund contributions, Public Provident Fund, fixed deposits (FD) and bonds. The equity bucket brims with direct stocks and equity funds. So far so good.
The toughest rule to wealth creation is Rule 3: Rebalance that portfolio.
What this rule says is this: If I start investing with a certain asset allocation in mind—say I am comfortable putting half my money in the equity bucket and the other half in risk-free debt bucket—I need to come back to this each year.
This I will do by selling the asset class that has risen more and buying the one that has fallen (or risen less). For example, if after the first year, equity rises 20% and debt gives an 8% return, then I sell some equity funds and put more money into an FD. If equity falls 20%, I break an FD and buy more equity funds.
Sounds great in theory, but does it work in the real world?
Let’s look at some data. I begin with a notional investment of Rs1 lakh in April 1990 and decide to split it equally between equity and debt. For the sake of neatness, I am making a one-time investment rather than a regular investment time series.
I choose that date since it was the time just before one of the biggest dips in the market index, and of course, this was near the beginning of the modern Indian equity market. For number crunching, I used the total returns data that includes not just the index’s rise and fall year-to-year, but also adds back dividends into the return. In this case, I used the CMIE Cospi total return index. For risk-free returns, I used the one-year FD rates taken from the Reserve Bank of India’s Handbook of Statistics for the same period.
So, it is 1990 and I’ve put Rs50,000 into the equity market and Rs50,000 into a one-year FD that gives me 9%. Over the year the stock market gives a total return of 37.72%. My equity bucket is now at Rs68,860 and my debt bucket has Rs54,500.
My 50:50 asset allocation is now off the rails and is at 56:44. Equity investing rules now insist that I sell equity (the outperforming asset class) and buy FDs (the underperforming asset class). This is the toughest call to make for investors worldwide—to sell an asset even as it soars each day.
For the sake of an argument, suppose I managed to rebalance my portfolio each year for 19 years. Now it is 2009 and my initial Rs1 lakh is Rs13.51 lakh. That’s a year-on-year return of 14.69%. Sounds good.
But what if I had not rebalanced and let the portfolio run on? I would have Rs8.38 lakh, or an average annual return of 11.84%.
The difference between the two annual rates of return may look just 3 percentage points away, but over 25 years it means being at Rs15 lakh or Rs30 lakh.
Punters call it profit booking—take a part of your money out when the markets are high or when a target price is met. But for the safe-lane driving, seatbelt-wearing retail investor, rebalancing is a great way to get the benefit of profit booking without the active calls or the index watching.
Equity investing is safe, but you got to follow the rules.
Monika Halan is a certified financial planner and policy analyst in the area of financial literacy and intermediation. Your comments and personal finance queries are welcome at expenseaccount@livemint.com
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First Published: Wed, Mar 18 2009. 01 15 AM IST