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.

No doubt that investing in equity seems to be very attractive option for investment. Why it so? We hear many stories, some true, some fictitious, of people who have become millionaire overnight. But the fact is, earning money is not at all easy on the stock market. Let’s accept this simple fact that it is not everybody’s cup of tea. So, we have to be very objective about it.

It is well understood universally that a diversified portfolio is less risky and much safe than a concentrated portfolio.

In India, small-time investors usually have a very limited capital for investment. Therefore, it follows that it is a lot more difficult for this investor with limited capital to have a diversified portfolio. In other words it is not possible for small-time investors to invest directly in the market and to make their portfolio diverse.

So, how can small investors get the opportunity to make their portfolio diverse? The only option left is investing in mutual fund. Mutual funds offer a well-diversified portfolio even with just Rs 100.

A concentrated portfolio, also, could deliver high or low returns. This means that, again, it is against the small investors’ investment appetite normally. It would suit only selected expert investors with high net-worth.

One more thing to notice is that with limited capital it is difficult for small investors to buy shares with high prices like ICICI Bank, Infosys, Reliance, L&T, and other blue chip shares.
Again mutual funds seem to be the better route.
Let’s now discuss equity and mutual funds from a different perspective keeping in mind the common man’s objective.

Let us be honest as far as possible. Ask yourself the following Yes/No questions:

• Reading balance sheet of the company as a fund manager might do
• Identifying up-coming sectors
• Knowledge about companies, market, economics, and politics as a well-experienced professional fund manager might have
• Identifying the risk elements in an investment
• Predicting the future of the market as per any given scenario

If you have all of the above capabilities, go on and make wealth! In most cases, however, the answers would be “No.” Most of us do not have time to learn all these aspects of investment. Even if we do, we may not be able to do it regularly. Mutual funds are well-equipped with fund managers to do all the above activities.
Let us just concentrate on our jobs and leave our wealth management to the pros.

In my last article I had mentioned that there are several methods, or styles, to investing profitably in the equity markets.

Let me start with suggesting that you, the potential investor, spend some time analysing your investments. If one were to assume that your money is indeed “hard earned”, would it not be unfortunate if is easily lost?

Most professional advisors compare their performance to benchmarks, which are indices. For example, if a fund generated returns of 20%, while its benchmark’s returns were 15%, this “outperformance” of the index by 5% is called an ‘Alpha’. This is a good measure to evaluate fund performance, provided the benchmark is reliable. If reliable, it would be a good measure to evaluate even personal portfolios returns.

The BSE Sensitivity Index of 30 shares is the most popular Indian stock market index. If one were to track this over 5 year periods, starting in 1992 (this is the year of the infamous Harshad Mehta boom, which is a relevant beginning simply because this is the first time there was retail participation in the capital markets), we would find that pre-2003 (the start of the latest boom), the index returned less than bank FDs. Even if we go from 1992 to the current date, the index returns are disappointing. This should indicate that equities are a poor long term investment, but are actually among the best options!

In fact, a well diversified portfolio, built over time and given a few years, at reasonable valuations (PE of close to 10, certainly lower than the Sensex’s long term average of 14 times) will outperform the benchmark or almost any other investment. The great Warren Buffet, however, considers that “wide diversification is only required when investors do not understand what they are doing”. If you know, and you need to know, why you make an investment, you should also have guts to invest plenty in it. Again, quoting Mr. Buffet, “Why not invest your assets in the companies you really like? As Mae West said, “Too much of a good thing can be wonderful.””

Diversification or concentration of portfolios can be achieved through investments in mutual funds. Concentration is through sectoral or thematic funds. Concentration is good only if you are an expert and can time your entry and, more importantly, your exits. Avoid being carried away by the noise. Most fund managers consider themselves to be God’s Greatest Gift to Investments (GGGI) in a bull market. However, when they crash with the markets they are quick to point to outperformance, if any, on the index, i.e. “The index has fallen 30%, but I have been brilliant and have lost only 25% of your money”. I have not met any investor who hands out money to be lost, whatever the market conditions. My advice is to ignore the froth from the fund managers, or brokers. If you are convinced the market is cheap, put in all your money. In an uncertain market do an SIP. But when the market seems overvalued sell. (By the way, have you ever heard a fund manager advice you to sell, or redeem your units in a bull market?) A crash always follows a euphoric bubble. Cash is supreme in bad times. It is a good feeling, and also very profitable to buy when the market is down 70%!!

Is this a good time to invest? Yes and no. An important lesson from Joseph Kennedy, almost a century old, is to sell when the shoe-shine boy gives stock tips. I believe this is true today. When the taxi driver is thrilled to take you to the share bazaar and asks for stock tips en route, the stranger at the party gives you sure shot stock bets and the daily newspaper has headlines of the local housewives club betting their grocery money on stocks – GET OUT. This is the best signal to sell your shares.

And buying? This would be when that party animal with best buys stops partying, the Big Bull has jumped off the 13th Floor and there is a funereal feeling at Dalal Street. Buy when the mention of a good company has people grit their teeth and give you dirty looks. And, of course, the index has a low, mouth watering PE!

One of my own gurus told me never to confuse the market with stocks. “The market is irrelevant”, he said, “buy the right stocks and you will always make money.” If you have his stock picking skills, which I do not, this article is not for you. If you are one of the simple folk, hoping to beat inflation and make a little money on your savings, the market at over 18 PE all this week (18.80 on Nifty on September 4, 2008) remains expensive. Look then for gems that might become multi-baggers.

Otherwise hang on to your precious cash. A better day to buy will dawn, when PEs are closer to 10 than 20. Get into SIP mode then. Market corrections can be both deep and long. Losing opportunity (interest cost of your money) is about as unfortunate as losing capital.

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

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