The stock market is at a lifetime high - should you buy, sell or hold?

A TV anchor was interviewing a fund manager when the market started to correct after touching a new high. The following is a brief excerpt of the Q&A session:

Q: You are holding 16% in cash. Is it because you are expecting a big correction in the market?

A: It's not like that. We hold a basket of stocks and have price targets for each stock. When a target is hit, we book profits.

Q: You mean several stocks have hit their targets during the recent rally - that is why you have excess cash? Why are you not redeploying in other stocks?

A: It is difficult to find new ideas near a market top, as everything appears overvalued. So, we have invested in money market instruments.

This is a classic problem that fund managers face. They can't afford to hold large amounts of cash because it affects fund performance. But they are wary of redeploying at high valuations in case the market turns against them.

Small investors with a long-term outlook need not be bothered by such a problem - provided they have a proper asset allocation plan.

The asset allocation plan will determine the investment strategy. How?

Let us look at an example - a plan with 70% in equity shares, 25% in fixed income instruments and 5% in cash. That means, out of a monthly saving of Rs 10000, Rs 7000 is being invested in an equity fund, Rs 2500 in a debt fund and Rs 500 in a liquid fund.

After a year, the invested amounts are Rs 84000 in the equity fund, Rs 30000 in the debt fund and Rs 6000 in the liquid fund. 

Due to the bull rally, the NAV of the equity fund has gone up 20% - so the amount in the equity fund has increased to Rs 100800. The amount in the debt fund has increased to Rs 31500 (say), and the amount in the liquid fund is Rs 6500.

The asset allocation has now changed (due to the rally) to 73% in equity fund, 22.5% in debt fund and 4.5% in liquid fund.

You now have three options: 
(i) book partial profits in equity fund and redeploy in debt and liquid funds to restore the original allocation and continue with your monthly SIPs; 
(ii) restore the original allocation by adjusting your monthly SIPs by investing less in equity fund and more in debt and liquid funds; 
(iii) continue with your monthly SIPs and ride the bull rally a little longer - allowing the equity allocation to rise to 75% before choosing options (i) or (ii).

From the point of view of simplicity, option (i) is the least complicated. The reallocation is suggested after one year to avoid paying any long-term capital gains tax on your equity fund profits.

What about the answer to the question? As was mentioned earlier - you have no need for it.

To diversify, or not to diversify? That is the question.

Diversifying - in the context of business and investments - means hedging your bets, instead of putting all your eggs in one basket.

What is the main benefit of diversifying? Reduction of risk. Say, you are supplying large plastic containers to domestic paint manufacturers and have built up a reasonably good clientele.

Out of the blue, demonetisation of bank notes is announced by the government. The real estate sector goes for a toss and paint manufacturers curtail production. A big supply order of containers that you were negotiating gets cancelled.

What will you do? Shout from the rooftops about what an ill-planned disaster demonetisation has been? Or, realise the need of ridding the financial system of large amounts of untaxed cash and look for alternatives?

One alternative is to look for opportunities at other organisations in the domestic market with a need for large plastic containers - like Edible oil manufacturers. That would be a diversification.

Another alternative is to look for opportunities in the export market. A third alternative may be to make small plastic containers - used by shampoo and hair-oil makers.

Without making too many changes to your expertise and production capabilities, you now have more opportunities of growing your business and reducing risk by operating in different markets and product categories.

Peter Lynch coined the term "di'worse'ification" for companies that diversify into unrelated businesses that destroy rather than create shareholder value. A classic example?  Reliance entering the telecom services business. 

As if one brother's disastrous foray into telecom services was not enough. Now, big brother is throwing more money into the same business. The result is likely to be equally disastrous.

What about diversifying in the investment arena? Should you, or shouldn't you? Most financial experts will recommend diversification for reducing risk. That doesn't mean you buy 20 equity funds or 50 stocks.

Real diversification means investing in different asset classes after making a financial plan and an asset allocation plan depending on your goals and risk profile. 

Investing partly in equity, partly in fixed income, partly in gold, partly in a liquid fund will provide a well-rounded portfolio across different market and interest cycles.

When the stock market is booming, stocks will provide huge returns. What if the market crashes - as it often does? Fixed income instruments will continue to provide lower but steady returns, and liquid funds can be transferred to buy equity funds at lower NAVs.

Is there a downside to a planned and well-diversified portfolio? Unfortunately, yes. You will generate steady, average returns, but are unlikely to get filthy rich.

How can you get filthy rich? By becoming the next Bill Gates. Gates stuck to a single line of business, and made sure the whole world will use his company's software through shrewd negotiations with computer makers. (His di'worse'ification efforts into electronic products haven't borne fruit.)

Moral of the story? For mere mortals - like you and me - a planned and well-diversified portfolio that reduces risk and provides steady returns over many years is the route to financial freedom.

Learn more: 
What Does Investment Diversification Really Mean?

Related Post

How to reallocate your assets

How many Mutual Funds should you hold to adequately diversify your portfolio?

If you ask that question to your friendly fund agent, he may say: "The more the merrier. The more funds you have the more diversified will be your portfolio." From his point of view, the answer may seem logical. 

If you listen to his suggestion, you may end up with 15 or 20 funds. There are so many funds to choose from - large-cap funds, mid-cap funds, small-cap funds, multi-cap funds, FMCG funds, banking funds, infrastructure funds, arbitrage funds, funds of funds, balanced funds, ELSS funds, gilt funds, short-term debt funds, long-term debt funds, income funds, liquid funds, gold funds, and so on.

After a year, you will find that your portfolio has under-performed the fixed deposit rates of banks because the good performance of some of the funds have been neutralised by the poor performance of the others.

So, what should a small investor do? The answer is: It depends. On what? On where you are in your investing/wealth-building stage.

If you are a young person who has just joined employment, investing your meagre monthly salary savings in one good balanced fund may serve your purpose and provide adequate diversification. 

The equity component of a balanced fund can comprise a mix of large-cap and mid-cap stocks. The debt component can comprise a mix of government securities, company fixed deposits, NCDs. 

The equity component takes care of growth. The debt component minimises downside risk. A balanced fund with 60-65% equity component is treated as an equity fund. That means they are not subject to long-term capital gains tax and dividends paid are tax free. 

Someone who has been working for a while, or is running a successful small business, more substantial monthly savings may be available for investment. In which case, a large-cap equity fund, a mid-cap/small-cap fund, an ELSS tax saving fund, a gold fund and a debt fund should provide adequate diversification.

What about all the other types of funds mentioned earlier? Aren't there money-making opportunities in them? 

Yes, if you have nothing better to do than monitor the performance of your funds regularly. Then you will be in a position to move in and out of your funds to increase returns - most of which may be eaten away by fees and taxes.

No, if you want your funds portfolio to run on auto-pilot while you spend your time and energy in furthering your career or growing your business.

Many investment advisors - particularly the ones who work in wealth management divisions of private banks - are clueless about what constitutes an adequately diversified funds portfolio.

Typically, they give you a suggested list of funds that are 5-star or 4-star rated by valueresearchonline.com or moneycontrol.com and expect you to choose from them. 

You may end up with 8 or 10 funds all of which hold Infosys, Reliance, L&T, HDFC Bank, Tata Motors among their top holdings. In which case, the performance of all your funds may depend on the performance of just these 5 stocks - giving you hardly any diversification.

You will be better off just buying these 5 stocks and not buying any of the suggested funds.

Remember that the more funds you have, the more time you will need to spend in monitoring their performances. Also, proper fund selection to avoid duplication of holdings will give you better portfolio diversification.

Last, but not the least, avoid the newer funds. Choose established funds that have a long-term returns track records.

Investment strategies in an election year – a guest post

Once again, general elections are upon us – an expensive exercise where Indian citizens get to elect their representatives to Parliament. India is a democracy – which is both good and bad. Good because everyone has a vote; bad because voters are forced to choose between candidates who are mainly in the fray for the money.

Opinion polls are pointing to a BJP victory. Such an outcome is likely to be good for business and economic growth – as per promises being made by the party’s PM nominee. How he will untangle the knots of bureaucracy and vested interests remains to be seen. A fractured mandate – which is a distinct possibility – could be disastrous for the stock market.

In this month’s guest post, Nishit looks at possible election outcomes and discusses investment strategies to navigate through post-election scenarios. Do you have an opinion on Nishit’s strategies? Feel free to express it.

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The National Elections are round the corner. So how does one play the elections? Elections tend to generate extreme reactions from the stock market. The Congress won in 2004 with Left support and we had 2 lower circuits. The Congress won in 2009 without Left support and we had a historic upper freeze in the market.

It would be interesting to see what happened in the months after that. In May 2004, the market hit a down freeze. The low point of May 2004 was never again breached by the market. This marked an important bottom for the market.

In May 2009, the market hit an upper circuit after the Congress victory. The market did give a buying opportunity in July 2009 but thereafter never dropped to those levels.

Let us see how the scenarios can play out. There are 3 possibilities after the election results.

1. BJP-led coalition wins
2. Congress-led collation wins
3. Third Front government comes to power

If there is a clear mandate for either a BJP or a Congress led government, then expect the market to rise. If a Third Front comes to power, expect the market to have a free fall.

We have seen in 2004 and 2009 that the market always gives a chance to buy. Right now the market has already touched 6300 and there can be a possible 10% up side from here.

What one can do is start accumulating cash in Liquid Funds and keep the cash ready for any eventual fall. Liquid funds give a return of 8-9% easily per annum.

Also, one can keep buying quality stocks. These stocks eventually give returns and can always be averaged out at lower levels.

One thing is very clear - one needs to have some portion of cash ready for buying after the elections. I would say at least 20% cash to capitalise on post election scenario.

Another alternative - if one has already bought stocks and has lower cash levels - is to hedge using Put Options. Options are a hedging mechanism and if used properly can insulate one’s portfolio against sudden falls in the market.

So, there are 3 options one could possibly take:

1. 80% stocks and 20% cash to buy on dips post elections
2. 90% stocks and hedging using Puts to hedge against any falls in the market post elections; the money from the Puts may come in handy
3. 70% stocks and using a mix of Puts and Calls to hedge one’s portfolio against election swings

It is essential to keep some portion in cash ready for buying after the elections. The opinion polls are pointing towards the BJP but polls can be unreliable. Opinion polls can point to a general trend but not the exact outcome. For all one knows, we may end up with a hung Parliament and a period of uncertainty.

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(Nishit Vadhavkar is a Quality Manager working at an IT MNC. Deciphering economics, equity markets and piercing the jargon to make it understandable to all is his passion. "We work hard for our money, our money should work even harder for us" is his motto.

Nishit blogs at Money Manthan.)

A low-risk investment option for uncertain times – a guest post

The stock markets have been in an unbearable state of ennui for quite some time. No clear trend is visible – leaving investors in a state of uncertainty. Without any entry load for funds, commissions have vanished from mutual fund houses. Distributors are no longer interested in pushing funds with fancy names. Most equity funds have been performing poorly.

What are low-risk investment options in uncertain times? In this month’s guest post, Nishit suggests that investors can take a look at Liquid Funds to park their savings, instead of keeping it idle in a current or savings account.

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Some time back, I had written about Gilt funds and the superb returns that they can provide in times when interest rates are falling. Gilt funds usually attract an exit load and redemption takes 3 working days.

One usually keeps a sum of money that can be readily accessed for emergencies in bank FDs or in a savings account. Savings accounts in India usually have a rate of Interest of 4% (Yes Bank with 7% and Kotak Bank with 6% for account balances above Rupees 1 lakh are exceptions rather than the norm).

Is there an option to earn more than the savings bank rate? One can look at Liquid funds. How do Liquid funds score over other debt instruments? They have 3 advantages:

1. No Exit Loads (some have 0.25% load if exited within 45 days)
2. Money is credited on the next business day as opposed to 3 days for Gilt funds
3. Average rates of return have varied between between 7% and 8%

Now to prove my argument, I have selected JM Money Manager Regular Growth fund. In the past 1 year it has given a return of 10.41% and over a period of 5 years an average return of 7.63%.

Liquid funds are especially useful if one is arranging cash for a large transaction and there is a chance that the money may lie idle in a savings account for a while. Liquid funds perform better when interest rates are high. Gilt funds perform poorly in a rising interest rate regime.

Also, liquid funds have low expense ratios in the range of 0.3-0.5% as compared to other mutual funds which charge 1-2%.

Liquid funds are one more way of diversifying your portfolio. Liquid funds are especially handy during year-end and advance tax payout periods where the 91 day T-Bill shows higher rate of returns.

For those interested in debt instruments, Gilt Funds and Liquid funds are two additional savings instruments. A well diversified debt portfolio will have exposure to all these asset classes along with Non-Convertible Debentures.

Liquid funds carry the risk of default by the issuer. If the fund size is small, exit by a large investor can adversely affect the fund. Hence, while selecting a liquid fund, the following factors need to be kept in mind:

• Size of the fund (should be at least 200 Crores in size).
• Fund house history.
• Fund history in terms of number of years the fund has been in existence. A 5 year track record is preferable.

Happy Investing!!

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(Nishit Vadhavkar is a Quality Manager working at an IT MNC. Deciphering economics, equity markets and piercing the jargon to make it understandable to all is his passion. "We work hard for our money, our money should work even harder for us" is his motto.

Nishit blogs at Money Manthan.)