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Strategies for an overheated market

Many mutual fund investors are worried that since the market has run up, they may be investing at elevated levels. Here is what you can do for favourable investment outcomes.

Strategies for an overheated market

"Uncertainty is the only certainty there is, and knowing how to live with insecurity is the only security." This quote by John Allen Paulos, a professor of mathematics at Temple University of the US, aptly sums up the market in 2020 and how investors should read it. In March, we saw one of the steepest falls in the markets worldwide. At that point, no expert could have ever predicted that by the end of 2020, we would have not only recouped all the losses but also scaled new markets peaks. And mind you, the party may not be over yet.

So, while in March, investors worried about the market bottom, now they are asking if the rally has already gone too far. After all, the economy has yet to fully recover and there is a threat of a second or a third wave of the pandemic. Of course, the vaccine appears to be within arm's reach, yet its distribution is going to be tricky. Given India's large population, inoculating even a fraction of population is going to be an uphill task.

But the market seems to have turned a blind eye to the negatives. For some, the conditions may be ripe for a shocker. The market is already sitting on a powder keg, just waiting for a spark. Some others are gung-ho like never before. They expect the rally to go on. Amid this, investors want to know what they should do now. Should they book their profits? Should they stay invested? Will part-profit-booking make sense? As always, there are no clear answers. But as always, that doesn't mean we can't plan and prepare ourselves.

The story of the rally
What lies behind the rally? Experts have suggested that one of the main reasons contributing to this swift recovery is infusion of liquidity by central banks around the world. Also, to prop up their sagging economies, governments have announced fat stimulus measures. That may have further buoyed the markets.

In India's case, there have been some macroeconomic tailwinds: a depreciating dollar, low crude prices, low interest rates in the US, etc. (see the chart 'Macroeconomic tailwinds').

India's Q2 GDP growth of -7.5 per cent is a much better number than Q1's -23.9 per cent. According to the IMF's World Economic Outlook report of October, though the current GDP growth of India has fallen by more than 10 per cent this year, it would rebound faster as compared to that of other emerging economies and world taken as a whole. Thus, FIIs have again started pouring money into Indian equities (see 'The FII-DII seesaw').

And of course, the news around the COVID vaccine is a major sentiment booster.

The party poopers
Not everything is hunky-dory, though. Inflation, as measured by the Consumer Price Index, has overshot the MPC-mandated upper bound of 6 per cent. While unlocking of the economy has unleashed the business, the consumer attitude and preferences may be shifting. That will keep the recovery of certain sectors in check for the foreseeable future - not to mention the permanent disruption caused by the pandemic.

The Sensex's valuations are already higher than the long-term average. If one goes by the theory of the reversion to the mean, the future course of the market is anybody's guess. Finally, talks of a second or a third wave of the pandemic and the complexities surrounding the distribution of the vaccine may throw a spanner in the works.

Fortunately, the investor is not out of ammunition in his arsenal.

The ultimate weapon: Asset allocation and rebalancing
An investor's asset allocation is his ultimate weapon against the wackiest of market moves. The idea is simple. You start with an asset allocation that fits your needs. That simply means dividing your investments across equity and debt in a certain proportion, say 75:25. Periodically, you rebalance so that you can restore the proportion. That means reducing your allocation to the asset class that has gained and raising it to the one that has dipped.

So, in March, as equities fell, you would have sold part of debt and invested in equities. Now that equities have gained, you would sell part of them and invest in debt. Thus, rebalancing automatically takes care of profit-booking and helps you invest in the asset class that offers more value at the moment. The effectiveness of rebalancing lies in it being counter-intuitive. You buy more of equity when the market is falling and shift to debt when the market is rising.

While rebalancing, be aware of the taxes and exit loads that may be applicable on your redemptions. Value Research Premium provides you insights into your asset allocation and any loads applicable on your investments, thus helping you make an informed decision.

The magic of SIPs
SIPs are your friend, no matter what the market condition may be. In bull markets like the ongoing one, your SIPs will automatically buy less. In a bear phase, they get you more units. In the long term, your total cost averages out. This makes timing the market unnecessary. It also saves you the mental work required to assess when you should invest and when you should not or if the market is too expensive or too attractive.

However, do continue with your SIPs through all phases, without getting deterred. Follow the simple SIP regime and not some 'smart' avatar of it. SIPs work best when they are also simple.

Keep your goals in mind
As an investor, what matters to you is what amount you realise when your goal is due. The intermittent rise and fall in your investment value are just noise. If your goal is due in the next few months or two-three years, it would be sensible to make a systematic exit from equities. But if your goal is still years away, there is little sense in losing your night's sleep over market movements. Just continue with your investment plan.

Trust your fund manager
When you invest in a mutual fund, you are effectively investing your faith in the fund manager to take care of your hard-earned money. During extreme market moves, it pays to remind yourself this. As a fund investor, it's not your job to worry about booking profits; it's your fund manager's job. He will exit the overpriced/less-deserving stocks and deploy your money in the rights avenues. Some fund managers may increase the cash holdings. Others may hedge the portfolio.

Whatever be the case, understand that your fund manager is far more conscious of market movements and valuations. He is also experienced and has more resources to make an informed decision. You should get into the selling mode only because you need money or because you want to invest elsewhere. Avoid booking profits for their own sake.

What about the recent outperformance by passive funds that only track an existing index? Since April this year, most active funds across categories have found it difficult to beat their respective indices. Isn't active management becoming obsolete? It would be too early to say so as active funds still beat the passive ones over long time horizons. More importantly, in the present times, where the role of an experienced fund manager is all the more crucial, passive funds provide little solace. With passive funds, while the portfolio may not be yours, you are virtually the fund manager. You have to decide whether you need to still hold the portfolio as it is fixed.