The avoidance of regret | Value Research Thinking about where the equity markets are going to go over the next few months? Don't worry about it

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The avoidance of regret

Thinking about where the equity markets are going to go over the next few months? Don't worry about it


Asset rebalancing is primarily a method of regret avoidance.

I know a lot of people will read that sentence and disagree, perhaps strongly. Whenever I talk of some financial technique (like SIPs, for example) as a psychological technique for investors to guide their own thinking, I get a lot of pushback on social media and on email. Investors love to think of themselves as rational beings (the well-known species Homo economicus) who take all decisions after logically evaluating every piece of evidence on merit. Nothing could be further from the truth. So, I'll stick to my guns.

Currently, many of us equity (or equity mutual fund) investors find ourselves in the middle of a situation where we wake up in the night and start worrying about the way stock prices have shot up in the last few months. For many investors, the time since last February, when the Chinese virus attacked in earnest, has been an emotional roller coaster. First panic, then relief, then excitement, then over-excitement, and finally, an increasing uneasiness. Could this be real? Will the equity markets get higher and higher, on their way to a strong and deep bull run that will last for a long time, or is doom imminent?

My answer is that in the short term, any answer is guesswork. Over a longer period, equity prices will head ever-higher. To explain why I'm saying this, I'll just say that this is the exact same answer I gave to someone in mid-2004 when I was asked that now that the Sensex had reached 5,000, surely it couldn't go much higher. It's an evergreen answer because it's always true.

However, back to asset allocation and asset rebalancing. The only solution to the above problem is to have a pre-decided asset allocation and not let yourself drift too far from it. Let's recap the basics. Asset rebalancing means that instead of seeing the equity-vs-fixed question as a black-vs-white binary choice, you should be seeing it as a shade of grey. Once every year or so, you could 'rebalance' your portfolio. What this means is that if the actual balance has veered away from your desired one, you should shift money from one to the other in order to attain that percentage again.

When equity is growing faster than fixed income - which is what you would expect most of the time - you would periodically sell some equity investments and invest the money in fixed income so that the balance would be restored. When equity starts lagging, you periodically sell some of your fixed income and move it into equity. This beautifully implements the basic idea of booking profits and investing in the beaten-down asset. Inevitably, things revert to the mean, and that means that when equity starts lagging, you have taken out some of your profits into a safe asset.

However, there is no need to over-intellectualise this whole business. There is no practical difference between 35 or 40 percent. My idea has always been that there are only three possible equity-vs-debt allocations. These are: (1) lots of equity; (2) lots of fixed income; and (3) a balance of equity and fixed income. That sounds hopelessly vague, does it not? In fact, it has all the precision you need. Practically, I would define it as 25 per cent, 50 per cent and 75 per cent. However, you can adjust it if you think it should be something else. Someone setting out to start earning, with very few liabilities in life could aim for high equity. As life goes on and you draw nearer to retirement, or there are some other troubles you foresee, move towards the balance. Then, as the end of your earning life draws nearer, shift to the other side.

If you get this right, then it is of very little importance whether the markets are going to crash or boom over the next few weeks or months. You will have avoided the regret of doing the wrong thing at the right time.

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