Smita (28) works with a multimedia company and has a monthly in-hand salary of about Rs 50,000. She invested Rs 1 lakh in equities in March when the stock market crashed. With the markets having recovered sharply over the past few weeks, the value of her equity investments has gone up by about 40 per cent.
She wants to know whether or not she should book profits by redeeming her investments. And if so, what proportion of the investments she should withdraw. Here are some suggestions for her.
You cannot 'time the market' perfectly every time
- l Smita has been lucky that the stock market recovered sharply soon after she made the investment during the crash in March. Now, it may give her an impression that the 'timing the market' is an easy thing to do and indeed a good strategy.
- But that's not right. The market moves unpredictably and no one can time it perfectly. Recall that no one had anticipated that the market would recover so soon and so sharply after the crash in March. But it did.
- Smita should consider this as a one-off instance. It would be wrong to expect such returns from equity investments in the future.
Missing the 'best' days of the market can cost you dearly
- Market movements are unpredictable and when you try to time the market, it is quite possible for you to miss out on some of the best days when the stock market makes maximum gains.
- Look at the graph titled 'Sensex's annual returns'. The annual return of the Sensex depletes significantly if you remove the best five days on which the Sensex made maximum gains.
- If considered from the long-term perspective, missing out on a single day just to time the market will deprive you of not only single-day gains but also the benefit of compounding, which you would have earned on the gains realised on the missed day.
- As you would notice in the graphs, staying invested is much better than facing the risk of missing even a handful of days.
- Even missing out on a handful of days when the stock market is at its best can reduce the value of your long-term money significantly.
- Similarly, as shown in the graph titled, 'Worth of Rs 1 lakh invested in the Sensex 15 years ago', one would have lost about Rs 1.86 lakh if one had missed staying invested on the five best days of the Sensex over the last 15 years.
- One may argue that it is not necessary that an investor only misses the 'best days' as there are 'worst days' too, when the stock market plunges. However, the truth is that no one knows which is the best or worst day of the stock market until it becomes history.
Don't redeem if your goal is far away
- Equities are meant for investors having a time horizon of at least five years. Do not invest in them if you are likely to need the money before that.
- One should stay invested throughout the tenure and avoid making unnecessary transactions. You will gain maximum benefits from equities if you stay invested for a longer time period, as you get to benefit from compounding.
- Smita should, therefore, remain invested and avoid redeeming the investments if she doesn't need the money now. She can link these investments to any of her long-term goals like retirement.
Follow an asset-allocation plan
- Having an asset-allocation plan in place helps you book profits in a systematic and methodical way.
- Devise a rule for rebalancing, say, you will rebalance at the end of every financial year, or whenever the asset allocation deviates by more than 10 per cent of the desired ratio.
- For example, if Smita decides a 75:25 allocation between equity and fixed income and now as the markets have gone up, she may liquidate 25 per cent of the portfolio and invest it in fixed income. Likewise, if the market crashes and the ratio becomes 60:40, she should liquidate 15 per cent of the portfolio from the fixed income and invest in equities to again make it 75:25.
Never invest in a lump sum
- Although Smita has been lucky this time, she should not have made any lump-sum investments. What if the market would have crashed further, say by 40 per cent, instead of moving up? Her investment would have reduced to just Rs 60,000.
- While investing in equities, one should always spread the investments over a period of time. Investing systematically through an SIP or STP reduces the risk of entering the market at the wrong level, as the purchase cost is averaged out.
- If you have a lump-sum amount, it should be spread over a few months. A rule of thumb is to spread it over half the time required to earn that money, up to a maximum of three years.
Don't ignore these
Emergency corpus: Always maintain a contingency corpus equivalent to at least six-month expenses. It can be maintained in a combination of a liquid fund and sweep-in deposit.
Life insurance: Buying life insurance is necessary only if you have financial dependents. Go for term insurance. Stay away from hybrid insurance products which claim to solve the dual purpose of investment and insurance. They provide neither adequately.
Health insurance: Have sufficient health cover for everyone in your family and it should be independent of the one provided by your employer.