Mechanical rules for investing

In the midst of the general meltdown of Zee Entertainment, I noticed an interesting tweet by the fund manager Samir Arora. Arora, who now runs his own fund company, Helios, was the fund manager for Alliance Mutual Fund in the 1998-2000 bull run. In the tweet, Arora pasted a screenshot of the Zee Entertainment stock price chart from 25 years ago - January 1998 to about April 2000. During this period, the Zee stock went up from Rs 4.58 to a peak of about Rs 778 (adjusted for a split) on February 24, 2000, and then collapsed. The tweet said, "Those were the days - by chance, it was the top holding in Alliance Funds through this bull run."

Someone who replied to that tweet asked when and why did Alliance sell that fund. Arora's response was that they had to sell every day for two years because the stock was at 10 per cent of their holding, and that was the limit for the maximum exposure that a mutual fund could have in a single stock. Eventually, when the stock was falling hard, they got out about 30 per cent down from the peak. Remember, this stock went up some 16,800 per cent during that period.

What happened to Zee is uninteresting today because such peaks and valleys are in the price history of many stocks. The interesting part - relevant to all of us who invest in stocks - is that a simple rule that enforced diversification and asset rebalancing was instrumental in the fund doing very well out of the stock. When an investment is going up sharply, the natural tendency of an investor is to hold on to it and perhaps even invest more and more. This feels like the best possible thing to do to maximise returns. However, in the excitement of daily higher prices, it's easy to forget the basic principles of investing.

In fact, even though the example above is of a single stock, I think it is a good way to understand asset allocation and rebalancing between stocks and fixed income as asset classes. If you are a saver or casual investor, you may not be familiar with asset allocation and asset rebalancing. Or you might think they sound complicated and not something you need to worry about. But actually, these concepts are straightforward and helpful. Asset rebalancing means periodically adjusting your portfolio to maintain your intended asset allocation.

Typically, equity grows faster than fixed income. During such times, you should periodically rebalance your portfolio by selling a portion of your equity investments and reallocating the funds to fixed income. This maintains the desired balance. Conversely, when equity underperforms, it's advisable to sell some fixed-income assets and invest in equity. This approach effectively captures the essence of realising profits and investing in undervalued assets. Over time, markets tend to revert to their mean, ensuring that when equity is underperforming, you've already secured some profits in a safer investment.

The important thing that the story above drives home is that this has to be automated and rules-driven - it has to be a process, not a subjective decision. If left to a subjective opinion, it will go wrong exactly when needed. The impact of this strategy is almost like magic. It reduces volatility, a major equity concern, while the returns remain robust. However, it requires too much activity and is not tax-efficient. Therefore, the most viable solution for most investors is using hybrid equity-debt funds. The reallocation between equity and debt is managed internally in these funds, so you don't face any tax implications until you withdraw the funds.

However, today's main takeaway is not just asset allocation and asset rebalancing but also how the basic principles of investing should be preset and applied via some process. The human temptation to get influenced by immediate events needs to be controlled.

Also read: Real, practical asset allocation