Money management

Srikumar Bondyopadhyay tells investors how to rejig assets for higher returns Small investors have been the biggest losers in the recent market mayhem. Experts say small investors follow a herd mentality, which means they buy in hordes when stock prices are high, but when the markets come crashing, they either get stuck or sell investments at a loss.

Profit is the ultimate goal of any investment planning. If an investment does not yield the desired result, book profits may turn into book losses when the markets plunge.

So, what should small investors do to beat the market blues?

Asset watch

First, as an investor, you need to set an investment goal for yourself and chalk out an asset allocation strategy that will help you achieve this target. You should regularly review the relative balance of your asset allocations. If there is any imbalance in excess of 10 per cent in a particular asset category, use this as a trigger to sell part of your investment in that asset class that has seen an appreciation to restore the balance.

It will also help you correct the timing of your entry into and exit from the markets.

Let us explain this with the help of an exercise (see chart). The table tells you how much money you need to invest now to help you become a crorepati after a given period of time.

It is clear from the chart that longer the period of your investment, lesser will be the capital required to be invested.

The illustration, however, considers only a one-time investment and no interim contributions after the initial endowment. So, if you have the required initial capital and are willing to make additional investments on a regular basis, you can become a crorepati quicker.

It also can be seen from the table that higher the rate of return, the lower is the initial capital requirement.

Risk-return nexus

However, it is the “rate of return” on the investment that throws up a tricky situation as different asset classes have different risk-return profile.

For example, you can get an 8 per cent rate of return for the next 5-10 years by stashing away your money in bank fixed deposits or any one (or a combination) of the state-run small savings schemes, such as NSC, PPF, Post Office Monthly Income Scheme. For such schemes, there is no fear of any capital loss.

You can spice up your returns a bit more by including debt mutual funds in your portfolio without significantly increasing the risk factor.

However, if you are looking at more than 10 per cent rate of return over the long term, you’ll have to invest at least part of your capital in equities, either directly through stock exchanges or through equity mutual funds.

Though equities generate higher return, they carry risk. So, you need to be judicious about asset allocation.

The rule book

There is a thumb rule for asset allocation. According to the rule, an investor’s equity allocation (as a percentage of total investment) should be equivalent to 100 minus the age of the individual. If you are 40-years-old, you should allocate 60 (= 100 - 40) per cent of your total in investment in equities or equity-linked instruments. The remaining 40 per cent should be invested in fixed income or debt instruments.

But if you are 60-years-old, you would rather need a steady flow of income from your investments. Hence, your equity exposure at the age of 60 should be much less (at 40 per cent) than when you were 40-years-old.

Hence, this asset allocation strategy follows the formula of lowering one’s investment risk with the growing age of the investor.

Market mood

Now, let us see how you can brave the market highs and lows using this strategy. Let us

consider a 40-year-old investor who has an initial capital of Rs 1 lakh. According to the asset allocation strategy, the investor will invest Rs 60,000 in equities and equity-linked instruments and Rs 40,000 in fixed income schemes and debt instruments.

Suppose, the fixed income plan fetches an annual rate of interest of 8 per cent. If equity prices go up 50 per cent in the next six months, the value of equity investment will be Rs 90,000 and the value of his fixed income investment will be Rs 41,600 at the end of the period.

A review of the investment portfolio after six months will reveal the following:

• The total investment has gone up to Rs 1,31,600, a gain of 31.6 per cent.
• Value of equity investment at Rs 90,000 constitutes 68.39 per cent of the total investment.
• Value of fixed income at Rs 41,600 comprises 31.61 per cent of total investment.

Here, we seen that an imbalance has cropped up following a 50 per cent rise in equity prices. The investor should restore the balance by bringing down the equity component of the portfolio to 60 per cent from 68.39 per cent and reinvesting the proceeds in fixed income instruments.

This means the investor should sell equities worth Rs 11,040 and reinvest the amount in fixed income instruments. Thus, after the rebalancing act, the revised portfolio will be:

• Total investment: Rs 1,31,600
• Equity investment: Rs 78,960, or 60 per cent of the total portfolio.
• Fixed income investment: Rs 52,640, or 40 per cent of total investment.

Now, if stock prices fall by 50 per cent in the next six months, the value of the equity portfolio will be Rs 39,480 and that of the fixed income investment will be Rs 54,745.60.

Total investment at the end of 12 months will, thus, stand at Rs 94,225.60. Equity and fixed-income assets comprise 41.9 per cent and 58.1 per cent, respectively, of the investment portfolio. This is again an instance of imbalance that can be restored by switching fixed income investments worth Rs 17,055 to equities.

After rebalancing, your equity investment will be Rs 56,535 (39,480 + 17,055).

If you had not gone for the rebalancing, then your initial equity investment of Rs 60000 would have come down to Rs 45,000 at the end of one year.

Thus, by adopting this asset allocation strategy, one can significantly reduce the investment loss if there is a steep decline in equity prices.

This was so because the investor was able to book profits from his equity investment when the market was up. On an overall portfolio basis, the loss is only Rs 5,774.40.