All NAVs in red? Try portfolio rebalancing!

[ajay7a]

Nowadays each day at the markets is a grim, gloomy and depressing story. Everyday we look at the markets with apprehension - How much will it fall today? How much more pain is left?

It has been a totally shocking scenario as the markets have crashed by almost 40% from 21,000+ levels to below 13,000 in just a matter of months. This is the story of the Sensex. The underlying story is much worse, wherein some stocks have crashed even by 70-80%.

The predominantly upward rise of the Sensex from around 3000 levels in March 2003 to 21,000 in January 2008 was a pleasant surprise. And, as Greed took over, people started taking undue risks.

Similarly, now the fall to 13,000 has come as an unpleasant shock and Fear has taken over. Investors are getting panicky.

It is but natural to experience Greed and Fear. But both these emotions are an enemy of our investments. While 'Greed' goads us to invest more & more, when common sense would dictate caution, 'Fear' induces us to sell when common sense would dictate patience.

So how do we overcome these emotions and ensure that we don't take any hasty decisions? One answer to this problem is the principle of Portfolio Rebalancing.

What is Portfolio Rebalancing?

One of the basic guidelines of investing is that we must have a clear-cut asset allocation between debt and equity based on our investment objectives, time horizon and risk appetite. Let's say we have Rs 10 lakh to invest and an equity-to-debt asset allocation of 60:40 suits our profile. Accordingly, we invest about Rs 6 lakh in equity funds and Rs 4 lakh in debt funds.

Suppose after 1 year, our equity funds have appreciated by 30% and debt by 7%, we would now have about Rs 7.8 lakh in equity and Rs 4.3 lakh in debt i.e. an equity-debt ratio of 64.5 : 35.5. This means that our asset allocation has become more risky and we need to rectify it. This is done by selling equity worth about Rs 0.55 lakh and investing in debt to restore the 60:40 ratio.

Alternatively say after 1 year, our equity portfolio has depreciated by 30% and debt increased by 7%. Thus now we would have Rs 4.2 lakh in equity and about Rs 4.3 lakh in debt i.e. an equity-debt ratio of 49.5 : 50.5. This means that our asset allocation has become more defensive and we need to rectify it. This is done by selling debt worth about Rs 0.89 lakh and investing in equity to restore the 60:40 ratio.

This, in a nutshell, is portfolio rebalancing.

Advantages of Portfolio Rebalancing

If we look at it closely, we find that:

* We have shifted the focus away from the markets. Thus we don't get swayed by its' irrational behaviour.
* We buy equity when the markets are down and sell when the markets are up. Isn't this what we should be doing? If we follow emotions, we do exactly the opposite i.e. sell low & buy high.
* We get certain critical decision-making triggers. If we look at the markets falling, we are not sure when to buy and how much to buy? Or if the markets are rising, we don't know when to sell and how much to sell? Both these questions are explicitly answered when we follow the portfolio-rebalancing rule.

In today's context, when the markets are crashing, portfolio rebalancing would suggest we buy equity funds.

This, of course, requires conviction in the growth potential of Indian economy. It is true that factors such as high oil prices (and climbing higher day-by-day), high inflation, political uncertainty, US recession, sub-prime crises, etc. will affect economic growth.

But does it mean that India will never bounce back? Will India not see 9%+ growth rate again? Will inflation remain double digit/near double digit for long time to come? We have seen many a crises in the past and come out stronger. So why not this time?

The final question, therefore, could be - What to buy?

One could possibly look at large-cap funds to begin with. Large companies have a better capability to survive a downturn. Mid-cap & small companies may not have that kind of staying power and resilience. Therefore, when the markets bounce back, large companies would probably be the first off the block. Later, as and when the economy gains momentum, mid-cap funds could be added.