Sunday, October 26, 2008

How to reallocate your assets

An investor friend asked me a million dollar question last week: The stock market has collapsed and blue chips are available at attractive valuations, but where is the cash to buy them?

Many investors - yours truly included - have been taken by surprise by the severity of the market decline. Let alone think about buying, many are scrambling to save whatever little is left of their portfolio. The currently attractive fixed deposit (FD) rates have prompted some to sell even at a loss and move to fixed income.

This is as great a time as any to give some thought to asset reallocation. But to do that we have to start with asset allocation.

Let us say that you are 35 years old and an investor in the stock market. The thumb rule for percentage allocation to equity suggested by market experts is (100 - your age). In this case, it will be (100 - 35 =) 65%.

Now you may not feel comfortable with the associated risk of such an allocation to equity. No one is pointing a gun at your head. Choose whatever percentage makes sense to you. 40-50% if you are a conservative investor. 75% if you are aggressive about making high returns with high risk.

The younger you are the more should be your equity allocation. Why? Because equities tend to earn the best returns over the long term, and when you start young you have less responsibilities and hence can afford to take more risk.

The older and closer to retirement you are, the more should be your allocation to fixed income. Why? Because the stock market can be in doldrums just when you are about to retire - when your regular income source will dry up. The (100 - age) formula comes in handy after all.

For argument's sake, if you agree with the 65% equity allocation (this could mean shares or equity MFs or a combination), the balance 35% should be in fixed income, gold ETF and cash. A rough breakup can be 25% in bank FD or Post Office MIS or PPF, 5% in gold ETF and 5% in cash.

The gold ETF is a hedge against inflation, but low returns may not permit a higher allocation. The cash is necessary for unforeseen opportunities - like a rights issue, or additional purchase due to a bonus issue or divestment.

If you have Rs 20 lakhs as an investible surplus, this asset allocation formula means Rs 13 lakhs in equity/MF, Rs 5 lakhs in fixed income, and Rs 1 lakh each in gold ETF and cash.

Investment guru Benjamin Graham had advocated that on no account should you let your equity allocation go beyond 75% or go below 25%. If you follow this advice to the letter and spirit, it will enable you to reallocate almost without thinking.

How? Say the stock market moves up (not likely in the near future!), and the value of your equity portfolio becomes Rs 18 lakhs. Your total investment value now becomes Rs 25 lakhs (=18+5+1+1), and your equity percentage becomes 72% (=18/25).

This is still below Graham's limit of 75% but is 7% above your original plan of 65%. Prudence requires that you start booking profits partially. If you are aggressive, you can ride the bull market till your equity value goes up to Rs 21 lakhs. Now you've hit the 75% level (=21/28). No further waiting - start selling and invest the proceeds into fixed income and cash, to return to your original percentage allocation plan.

What happens in the process is you increase your wealth in real terms - not only on paper, because now your fixed income/cash amounts have increased. The actual figures are about Rs18 lakhs in equity, Rs 7 lakhs in fixed income and Rs 1.5 lakhs each in gold ETF and cash.

Thanks to the bear market, let us assume your equity value drops to Rs 10 lakhs. Your total investment value is now back to Rs 20 lakhs (=10+7+1.5+1.5) but your equity allocation is down to 50%.

Guess what? You now have some extra cash to deploy back into the market. And if you opt for Post Office MIS and/or monthly/quarterly interest from your FD in your fixed income allocation - then you will have even more cash without touching your FDs or gold ETFs.

No wonder Warren Buffett has said that knowledge of simple arithmetic is enough to be a smart investor! (In real life, the arithmetic may become a little more complicated - but an Excel spreadsheet should take care of that.)

Sunday, October 19, 2008

Three phases of a Bear Market

I have been receiving a number of queries and comments about what to do now, whether the bottom is near, and if this is a good time to start putting some money back into the markets. For many investors this may be the first real taste of a bear market, so these queries need addressing.

To get some idea of what to do next - and I've already voiced my opinion of the benefits of 'doing nothing till we hear from Mr Market' - one should be aware at which phase of the bear market we might be in.

There are three distinct phases in a bear market.  The first phase can be called a 'distribution' phase if you are an enlightened investor, or a 'denial' phase if you are a newbie. Smart investors start exiting the market, 'distributing' their stocks mostly to the late entrants who got caught up in the hype of the bull run.

The consequent fall in the index is looked upon as a bull market correction by the less informed investors, who follow their prior 'buy on dips' successes to buy some more. This in turn causes the first of the bear market rallies which is not supported by the smart investors. The rally peters out making a lower top.

When the second down phase starts, concerned investors begin to realise that this may be a bear market after all and start selling off. Buyers are few and far between. Volumes become lower and the market makes new lows every day.  A few disbelievers still hang in there and think that the market has bottomed.  There is usually a short upward rally which soon fizzles out and the market heads down again.

Now the fundamental news and company results start getting weaker and more negative. Every one becomes fully bearish and stocks are sold at any price leading to a complete 'capitulation' phase. Investors become risk averse and look for safe options like fixed deposits to protect their capital. The stage is now set for the recovery.

A fairly prolonged bottom formation happens now. Prices tend to drift sideways and then marginally down, but at a much slower speed than the earlier two phases. Finally the bear market ends when all the possible negative news gets discounted and smart investors begin to enter for the first or 'accumulation' phase of the new bull market.

So where are we now? We have definitely gone through the first two phases and are probably at the last stages of the final 'capitulation' phase. While no one can say where the final bottom will be, it looks like we are getting pretty close to it.

Is it a time to start buying? As a fairly conservative investor, my take is to wait till the first confirmation of an up move is received. That may mean waiting for 6-8 months more and buying at prices 10-20% higher than what they are now. If you are less conservative and wish to buy now, stick to large cap stocks and be prepared for a longish period of little or no returns.

Sunday, October 12, 2008

When the going gets tough, do nothing

Edward Kennedy 'Duke' Ellington was a well-known jazz pianist who later became a famous composer and band leader. Considered by many to be one of the foremost influences in jazz, his complex compositions and arrangements brought jazz to the mainstream of American music.

Many of his compositions have become jazz 'standards' - recorded and performed by a whole host of singers and musicians through the years. Some, like 'Caravan', became so popular that even pop instrumentalists performed and recorded the song.

One of Duke's compositions - 'Do nothing till you hear from me' - has relevance to the current state of the Indian stock market, if you replace 'me' with 'Mr Market'!

With the market hitting new lows every day, many small investors are utterly perplexed about what to do. Some feel this is a great time to buy. Others have seen their portfolios erode away and are thinking about selling and getting out. The more adventurous ones are writing puts and calls and probably making their brokers rich! Risk averse investors are looking at FDs and FMPs. But the really smart ones are riding out the market turmoil by doing nothing.

An avid mountain climber once commented about his frequent attempts at climbing the Everest: 'I try to climb the Everest because it is there!' Well, the stock market is very much there - and will be there for quite some time longer! Does that mean that you should always be buying and selling?

However, 'do nothing' does not mean 'remain completely inactive'. This is a great time to do fundamental analysis of companies - particularly the large cap ones. Find out which ones are offering greater value in terms of dividend yields, price to book value ratios, operating cash flows, profit margins.

Make a short list of such companies and track them on a daily basis. Then wait to hear from Mr Market. He will start giving you diverse and interesting clues - such as, lower interest rates, an increase in the advance-to-decline ratio, an aversion to discussion about the stock market among your market-savvy friends.

The cumulative effect of such clues will indicate that the worst may be over. Till you hear from me (I mean, Mr Market), take your spouse out for a candlelit dinner, take that dream holiday to Mauritius or Machu Picchu but do nothing about buying or selling in the stock market.

If you absolutely must buy or sell, at least wait for the Q2 results. Looks like this one is going to be a long bear market.

Sunday, October 5, 2008

Start your own risk free FMP

We have now spent 9 months in a bear market. For investors who had entered the markets in the last 5 years, this is the first experience of how a bear market can destroy wealth.

What we saw in 2004 and 2006 were just bear phases in a bull market, which provided opportunities to buy.  Many small investors jumped in to buy in March and July this year - only to see that there was no real recovery in the markets.

Experts have now started talking about a 4-digit Sensex, and investors who have been in denial for the past 9 months are now thinking and talking about how to protect capital and reduce losses.

The mutual fund industry has been promoting Fixed Maturity Plans (FMPs) of 12 months+ duration and trying to explain the benefits of lower tax against a bank fixed deposit. Of late, they have even started offering 1 month FMPs - and are not mentioning anything about tax benefits!

A small investor trying to protect his capital should start his own FMP and make it completely risk free. How? It is so simple, that it is almost a no-brainer.

Let us say you have some investable cash of Rs 2 lakhs. What are your options?

a) You can buy shares at low prices and watch them go lower;

b) You can buy MF units and watch their NAV drop

c) You can park it in a bank FD for 2 years and earn 10% interest

d) Start your own FMP - start with Option (c) above, but take monthly or quarterly simple interest. Depending on your risk tolerance, set up a recurring deposit (RD) account with 20% or 50% of your monthly/quarterly interest. The balance interest should stay parked in your savings account for periodic purchases of shares and/or MF units. 

After 2 years, when your FD matures your entire capital will be intact, the RD account would be intact as well, and the shares or MF units that you purchase should start showing some real gains, as this bear market should be history by then.

Simple, isn't it? But exciting? No. But who said building wealth is exciting? It is a slow and steady and disciplined process to be carried through for many years.

(I try to preach what I practice. In Oct '07, I had sold a percentage of my holdings in shares and MF units when the market looked overbought. With the proceeds, I opened a 3 years FD with a leading private bank. 20% of the quarterly interest earned is reinvested in a RD. The balance interest is accumulating in a savings account. I have slowly started to reinvest in shares and MF units.)