BackHow to navigate your portfolio through a stock market bubble
It makes sense to stick to your asset allocation in volatile market conditions like the one prevailing now
PremiumIn the period from 23 March to 21 August 2020, the Nifty has gained close to 50%. Even at these levels, the index is lower than what it was when it hit its all-time high in mid-January. Still, there is a debate on whether equity investors should consider the markets as expensively valued and apply a brake on their investments. This is primarily because of the impact of covid-19 on the real economy and the risks to growth and income combined with fears of asset class bubbles in equity and gold on the back of global liquidity.
However, the systematic investment plans (SIP) inflow into the equity markets remains strong, indicating either of two investor behaviour traits. One, they have faith that the markets will correct any imbalance between price and value over time. Two, they are lazy about making any changes as they see SIPs as efficient and adequate to manage risks.
But what is the best course of action in these circumstances? Do you exit stock markets at this stage and wait for valuations to moderate? Do you continue your SIPs and take solace in the fact that a long-term horizon will give your the headspace to deal with the volatility? Or is there another way?
Using SIPs
SIPs can’t be the tool to remove risk completely from a portfolio. Irrespective of how the units in a mutual fund are acquired, the entire corpus will be affected by a fall in the net asset value (NAV) if markets decline and the returns will see volatility.
A benefit that periodic investments such as SIPs bring is averaging acquisition costs since units are bought at different levels of NAV. If more units are purchased when NAVs are lower, it brings down the average cost.
While this may hold true in the initial stages of accumulation, once the corpus is large, the positive impact of buying additional units when markets are down will be minimal when compared to the fall in the corpus value as a result of a decline in NAVs. To make a real impact on the average cost of acquisition at this stage, you’ll need to invest a large sum of money as regular SIP instalments alone will not make a dent.
If you redeem the units when the market is down, then the corpus value will be lower to reflect the fall in NAV and an SIP cannot protect against that.
Use tools like SIPs to bring discipline and streamline your saving and investment plan, but understand their limitations.
What you should do?
In conditions of market disruptions, like we are seeing now, use SIPs in conjunction with some active measures to lead your portfolio towards a better outcome.
Have an asset allocation that suits your needs for growth, income and liquidity and rebalance it periodically to protect downside risk while making the most of market corrections. “We can’t predict if or when markets will correct. Track your allocation closely and if you have more equity than you are comfortable with, then invest in fixed income and international funds to rebalance and give some cushion in a market correction. But on no account should you consider stopping the investments or invest more into equity than you are comfortable with due to the fear of missing out," said Deepak Shenoy, founder and CEO, Capitalmind.
Due to the sharp run-up in the last five months, equity would have overshot its limits in most portfolios. Rebalance the portfolio to its pre-determined allocation. This will not only help book profits but also reduce the risk since the portfolio’s exposure to equity has been brought down to a level that the investor is comfortable with. If markets correct sharply, the impact on the portfolio will be lower and rebalancing at that stage will mean buying more equity when markets are down.
“We look at the portfolio allocations on a quarterly basis and adjust investments across asset classes," said Priya Sunder director and co-founder at PeakAlpha Investments. In situations of extreme market movements rebalancing the portfolio more regularly rather than annually helps manage risks and capture market opportunities better.
Keep tax and other costs in mind while doing this. If you are a long-term investor whose portfolio demands equity and have the stomach not to panic if there is a deep correction, then staying invested in equity and adjusting the allocation is the route to take.
Moving to an asset allocation fund, which has debt to cushion the falls in equity, is an option if you find yourself in either of these two situations. One, if you are a long-term investor but would like a smoother ride given the uncertainties. Two, if your goals are closer and you would not like to see an erosion in the accumulated corpus even if you still have the time frame to remain invested in pure equity.
“Dynamic asset allocation funds make allocation adjustments between equity and debt according to market conditions. Investors who are willing to trade off lower returns than pure equity for a smoother ride should consider them," said Gajendra Kothari, managing director of Etica Wealth Management Pvt. Ltd. “Our model indicates that equity is in an elevated risk zone at this stage. For investors who are not comfortable with capital erosion, we recommend moving to an asset allocation fund which will give some participation in equity without heightened volatility," he added. The firm plans to revert to pure equity exposures when it is comfortable with market valuations.
If you are staring at uncertainty of income, focus on stability and liquidity and stay away from equity till there is better visibility. “For clients who are facing disruptions to income, it is important to build liquidity. Continuing to build long-term assets like equity at this juncture does not make sense," said Sunder.
If would like to fish in troubled waters, tactical allocations to equity when markets see a correction and sectors that are expected to do well in the current scenario are options to consider. But be clear about the risks involved.
“For higher risk allocations such as small-cap and sector funds, timing entry and exit is important to make the best returns for the risk taken," said Kothari, pointing out to his own investments in the pharma sector two years back when there was no expectation from it to outperform the market and the return he has made since.
Sunder stresses the need to revert to long-term allocation once the tactical opportunity has played out. “We did increase the allocation to equity for some clients in March to make the most of the market correction. However, we made sure there was visibility on future cash flows, such as a bonus, to be able to adjust the allocation quickly later," she said.
The fears of a market correction given the disruptions are real and it may be time for you to get more involved in managing your portfolio. Consult an adviser to focus on what you can control instead of getting influenced by the state of the economy and the markets which you can’t predict.
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