Written by Joydeep Sen.
The stock market has been in a secular uptrend since March 2020. Some investors are concerned about a possible correction, and are questioning the right approach, from the perspective of partial profit booking or a simple defensive approach. AMCs’ balanced benefit funds are receiving booming inflows from investors, who are reluctant to take on higher equity risks at this point.
Your portfolio consists of different asset classes like equity, debt, gold, etc. The allocation ratio to different investment assets is determined according to the risk profile, time horizon, investment objectives, risk profile of the asset class, etc. Apart from these aspects, the allocation ratio acts as a powerful tool from a different perspective.
When you rebalance your portfolio and go back to the allocation ratio you initially set, you are making purchases in a bear market and locking in profits in a bull market. This is a system that pays to book partial profit at higher ratings and induces purchases at lower ratings.
Illustration and action point
As an illustration, the investor follows an allocation ratio of 60:40, 60% in equity and 40% in fixed income. In the January-March 2020 stock market correction phase, the equity allocation could have been materially lower than 60% (after correction) and debt increased to over 40% (due to the equity and debt receivables correction ). If he had rebalanced in March 2020, he would have bought that much stock to restore the balance. This would lead to low-priced purchases.
Cut to the current context. After rising over the past year and a half, if the allotment was decided in a ratio of 60:40, the equity component would be above 60%. Whether the correction occurs or not, if you restore the balance, you will book a partial profit. You cannot control the market, but by controlling your portfolio’s asset allocation, you will have some control over the potential fluctuations in your portfolio.
Rebalancing faces a psychological hurdle: partially switching from a high yield route (eg this gives me a 15% return over the long run) to a lower yield route (eg the debt expectation is only 6% now). On the flip side, when the market is at its lowest, one tends to hold out (it will get cheaper after a few days, I’ll buy then). This is where you should separate your emotions from your financial investments.
The rationale for doing this is to not run after the path of the highest return investment, as returns from different categories vary each year, in every market cycle. The rationale is that your portfolio should give you the optimal score, adjusted for volatility. This means that your journey should be relatively smooth. Attempting to predict the level of markets is futile; What is under your control is the portfolio you create to fit your goals.
The 60:40 ratio mentioned above is for illustration only; The longer your horizon, the higher the equity allocation can be – provided you don’t have to worry about potholes down the road, i.e. volatility. The point in time at which you should rebalance cannot be determined; When there is a steady or upward trend and the ratio has deviated significantly from your intentions, it is time to do so.
The writer is a corporate coach and author