The recent situation in the stock market has left most wondering how and by what means they can make some gains; or for that matter just not incur losses and preserve their capital to the extent possible without any erosion.

With some mix and match, investors can reduce the risk and save their capital from eroding. By making some informed decisions and application of some proven investments principles that have withstood the test of good as well as not so good times in the stock market.

Let’s start with an example.

Ajay and Vijay, both in their early thirties are employed at a reputed MNC company. Both of them are active investors in the stock market, keen followers of its movements.  Their experience in the stock market and the continuous flow of information through various mediums like newspapers, internet, and television has made them aware of that equity gives the highest possible returns over the long-term. Also their experience has taught them how to go about asset allocation. Ajay and Vijay both have split their investible surplus in equity as well as debt. Both invest their surplus in a 70: 30 equity-debt ratio.

But the recent market slump has baffled even them as to what strategy they need to adopt; they are in a state of panic and do not know what to do to save their investments or at least prevent capital erosion.

Most people are aware of the fact that they need to hold their investments for the long term for better gains; but here the point - what is long term? And how do we know that this is the right time to sell or buy? I have come across people who told me that if they would have had sold their portfolio in January 2008, they would have definitely made good gains. But then, at the time there was this positivity all over with everyone expecting the BSE index to reach 25000+. And now that the markets have climbed downwards these same people are expecting the index to touch lower levels. There is no way to find as to whether the indices have reached their peak or they have bottomed out. Markets are sentiments driven. You can is no way time the market.

There is no simple way out. You need to be patient and more importantly, there is no need to keep your distance from the market. Here is another question: What should the retail investor in the present situation and till the time the markets return back to their original glory?

The answer is ‘constant mix portfolio rebalancing’ and Ajay has adopted this strategy. His financial planner suggested that this would insulate him from market turbulence while ensuring that he remains the king of good times.

So, what is constant mix portfolio rebalancing? And how does it work?

Constant mix rebalancing is where you calculate the initial proportion of each investment in the portfolio and then maintain that ratio at all times.

As investments go, equity investments give a far higher rate of return than debt investments. Debt returns are more conservative, usually pegged at 10% year-on-year. Hence, over a longish period, an equity-debt portfolio that starts off as a 70-30 split can become lopsided in the equity section’s favor.

So, you constantly rebalance your portfolio by liquidating enough of your profits from the equity section of your portfolio and transferring it into the debt side, to keep up the 70-30 split between equity and debt.

Given below are the tables that tell two tales - Vijay who started off with his 70-30 split but didn’t bother to rebalance, preferring to buy and hold. And Ajay, who did indeed rebalance his portfolio every year to keep up the 70-30 equity-debt split.

Vijay’s portfolio

Look at year 2. The equity investment grew at 30% while debt plodded on at a steady 10%. The total corpus at the end of year two was Rs. 124,000. But the equity-debt split is no longer 70-30.

So, Ajay calculates:

70% of 124000 = 86800, while his equity holdings total 91,000, an extra 4200. So, Ajay transfers this to the debt section, thus keeping the 70-30 ratio intact.

What happens when Ajay keeps doing this? In year 5, when the stock market goes to the dogs, Ajay’s losses in his equity investments are eminently minimal. But more importantly, he has managed to avoid capital erosion.

Vijay, on the other hand, sticking to his buy-and-hold policy, suffers a 34% loss on his equity capital plus huge capital erosion.

Portfolio rebalancing is vital part of investment policy. There can be no asset allocation target without the discipline to preserve that target. Buy low sell-high strategy has most of the times been advocated by experts but greedy investors always fail to follow this principle. Constant mix rebalancing is mechanism for sensible timing of index movement. Through this process the investor naturally buys low and sells high and the most important benefit is it reduces the risk to greater extent ensuring adequately diversified portfolio.

Inflation is a money eater that reduces your purchasing power. For instance if the average rate of inflation is 8%, you need to make sure that your investments are earning a minimum of 8% or more, post-tax. Let us assume an investment portfolio of Rs. 1, 00,000, earning returns at 10% and inflation at 8%. The returns in this case would be Rs. 10,000 gross annually, with the net after income tax Rs. 7000 (Assuming you are in the highest tax bracket of 30%). Now if you account for the 8% inflation specified (8000, or 8% of Rs. 100,000), you are left with Rs. -1000 (Return of 7000 minus inflation of 8000)! The best way to grow a retirement corpus is to have a diversified investment portfolio according to the asset allocation designed for your risk profile. An ideal one would be 40% equity (blue chip), 50% debt, 5% gold, and 5% cash. Equity would help appreciate the retirement corpus. Debt investments would provide for regular income and gold would act as a hedge to inflation and equity turmoil. The recent equity market downturn was the perfect example for gold to stand out as a surge. Selective equity investments made for the long term are more often than not investments with high returns.

Equity: Do not sell blue chip stocks when the value increases. This should not be done when you planning for retirement. These stocks provide for the regular incomes by the way of dividends. At the same time if the dividends paid by the companies increase, it will reflect positively on the stock price too. The most crucial aspect that we never consider in an investment is the dividend that companies pay. We always look at just the capital appreciation. Dividend income in India is tax-free. The dividend payouts by all good companies grow proportionate to the growth in the net profit. It means that if you stay invested, your equity dividend income will keep growing year after year, compounded. If you think that the return on your capital is tiny compared to your investments, just be patient and watch out for a few years. Lets assume that your company’s dividend payout grows 20% year on year, in 10 years your dividend income will jump by more than 6 times and in 20 years it will go up by nearly 40 times. And if you consider the occupational windfall gains like rights and bonus issues, your dividend income goes up in compounding multiples over a period of time.

Your Investments should perform better than the market: Is it easy? Yes quite possible. The Bombay Stock Exchange has approximately 3000 shares listed on it but its index, the Sensex, is a weighted average representation of just 30 stocks. So, if the Sensex falls it is an indication that the heavy weights from the 30 stocks fell; not all the 3000 stocks. If your investment portfolio is to beat the Sensex, they will need to have a Beta more than 1. The Beta is a measure of sensitivity of a scrip movement relative to the movement of the benchmark index (in this case, the Sensex). A Beta of 1 means that for every 1% change in the index, your scrip moves by 1%. The caution here is that when you have a Beta of more than 1, your investments will also fall faster than the Sensex fall. Investments in stocks can be very rewarding but with high risk.

If you lack knowledge let mutual funds take care of it: I believe most of you investors who lack knowledge should rely on mutual funds, not individual common stocks. This is not because I think your performance will not be better; rather I think it will be easier for you to operate and will allow less potential for a catastrophe. Investments in mutual funds are managed by professionals who understand and study all the critical aspects before investing your money. This will help in proper diversification, but be sure of you choosing the right scheme to invest in as per your risk profile and aspirations.

Let your debt investments comprise of Government securities and highly-rated bonds (AAA): The most important component in a diversified portfolio is investment-grade fixed income. High-grade bonds and full-faith-and-credit-pledge government securities are the most reliable fixed-income counter balancers.

The balance between debt and equities is a function of (1) your age - the younger you are, the larger your equities percentage; (2) your financial resources; and (3) your need for current income. No two investors have exactly the same risk/reward profile.

Once your debt investments are in place, you need to make adjustments and additions from time to time depending on your changing needs and available new cash for investment. But you should keep rebalancing the portfolio according to your asset allocation strategy once a year.

Biggest mistake is investing based on events: You should never make investment decisions reacting to short term economic indicators or performance. You should build long-term wealth by investing in good companies with strong balance sheets and a history of paying and increasing dividends, and then you remain patient. You don’t jump in and out of stocks based on quarterly earnings reports. Base your investment program on business cycle trends, not market noise created by events.

You should not make many changes to your portfolio in the course of an average year. You should add money to some positions and tinker with others. You should not run from one idea to the next each time the economic wind changes direction.

I would like to urge all the investors reading this to begin weeding out your portfolio’s deadwood. Simplify and organize your investing, and practice the basic rules. As you start to see the profits rolling your way, you’ll be glad that you took the time to read this article to lay a solid investment foundation.

Kirtan Shah, a Certified Financial Planner, is a partner at AmbestinQ Consultancy Services.

I had just started college in 1981. Some saved pocket money and small prizes added up to Rs. 125, which became my first investment in shares. 3 years later I got out of college with some education, a portfolio of about Rs. 10,000 and a lesson in keeping my mouth shut…Knowing my dad also had some investments in shares (from the addresses on the mail) I mentioned a particular stock at home. Dad promptly took me out and warned me never to speak of shares in my grandmother’s hearing. The belief was that investing in shares was as big a sin as gambling – anathema for a small town middle class family.

Stories of legendary wealth created from investments (Warren Buffet, according to an email doing its regular rounds, started at age 11 and used profits to buy a farm at 14, to turning into one of the richest men in the world), to tales of suicides by big losers would suggest that investments in shares is gambling and that the stock market is a huge gambling den. Is it?

Starting at the beginning, what is a share? If I may use examples, a person starting a small business could use his/her money, if a little more money were needed. He/she could rope in friends as partners, or borrow from banks, but would be hard-pressed if the capital required were substantially larger. Such a businessman could split the entire owners’ capital into small units, of normally Rs. 10 and sell it to a large number of ‘investors’, each being a partner in the business to the extent of the money invested (’shares’ bought). The business would be in the form of a ‘Joint Stock Company’ (Company).

The share market? If the investor, from my previous paragraph, had invested in a share of a profitable company, others interested in being a part of the venture would try to buy shares in that company. This would take the prices up. Conversely, if the company were not profitable the holders would try to sell it bringing down the price of the shares. The share market is a forum that facilitates and controls the transactions, to ensure the investors’ transactions are safeguarded.

This does not mean that the stock exchange guarantees profits to all investors. Every transaction of a share bought involves another where a share is sold (shares are not created at will). While the buyer would purchase a share expecting the price to go up, the seller would expect it to drop. One would be right. The Stock Exchange is a place where a seller can find a buyer. The Exchange also ensures that the buyer receives his shares and seller his payment.

Returning to the beginning and my grandmother? How is investing different from gambling? While gambling involves chance (I do not know anything more about gambling in any form), investing involves the science of numbers. All stocks traded (stocks are bundles of shares) are at a price. This price is normally based on measurable factors, including but not limited to the profit of the company (from which is derived the profit per share, also called Earnings per Share or EPS), Book Value (which indicates the amount of profit plowed back in the business), ROE (Return on Equity) and ROCE (Return on Capital Employed, showing how well money has been used to make profits by the Company). Out of these come other ratios relevant to the price, like PE (Price/ Earnings, a fundamental value), PEG (PE/ Growth), P/BV (Price/ Book Value) and others. The market becomes a casino when these values are ignored and shares are bought because it is fashionable to have some!

The guru of investors, Warren Buffet, has said that he considers ROE, followed by PE, the most important values.

Returns are the most important simply because that is the reason for any investment. With a number of options available, the investor would be unwise to use the less profitable. Therefore, knowing that your company earns reasonable returns on the money invested in its business (Return on Equity and Return on Capital Employed) is the basic parameter to value a company and its share.

PE tells us the price we pay for the returns. Simply PE is the number of years it takes to get your investment back as profits, at the present rate of profit. Obviously the investor would like to recover his investment early, so a small PE would normally be better. An example, most small businesses are started with loans from parents or uncles, autorickshaws, fruit juice stalls, vegetable vending and the like, which are numerous successful businesses in India. The loans are taken with a promise to repay (mostly honored) the loan after deducting daily personal expenses. The loans are to be repaid in 2 or 3 years, indicating a PE of 2 or 3. Would the lending ‘uncle’ be as generous if the loan were to be repaid in 30 years? I doubt it. But in shares investors often disregard their ‘pay-back’ period (the BSE Sensex was at a PE of 30 a few months ago), clearly indicating gambling was getting the better of investing. The market fall to a current level of about 18 PE was a natural phenomenon of valuations and better sense descending!

There are several methods to investing and they will be covered in time. The most important is to invest with some knowledge. Data is available today, as easily to the rookie, as a professional. If the money invested is hard earned, the investor has a duty to himself, to see that the money is not lost to stupidity. Three basic types of research are Fundamental, Technical and Logical.

Fundamental research is a study of the Profit & Loss account, as well as the balance sheet of a company to check the financial health and profitability of the business. The ratios mentioned earlier all stem from this.

Technical research is a study of graphs and patterns, best left to experts. This is used to identify the best time to buy, or sell, a stock.

Logical research is simply keeping ones eyes open. The daily news often provides information on opportunities. For example, increases in interest rates hurts companies that borrow, and banks that would see erosion in the value of their bond portfolios. Increased customs duty on steel would benefit the local steel manufacturers.

Till we meet again, a word of advise. Gather some knowledge, or go to experts (through Mutual Funds). Invest so that you keep your losses low (therefore invest cheap – not at low prices, but at cheap valuations). Prefer to lose opportunities, not money (Buffet’s 2 rules to his managers are:

1) Never lose your investors’ money

2) Never forget Rule 1

May your investments be profitable and your days peaceful.

Naveen Fernandes is a Certified Financial Planner and Vice-president, Orbis Financial Corporation Ltd, Mumbai. Orbis Financial is a SEBI-approved custodian.