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Despite volatility raising its scary head at every turn, there's a simple way to figure out whether to buy, sell, or hold...

Even though this magazine is brand new and this is only the second issue that you are reading, what we are about to tell you in this article is one of the oldest pieces of advice that anyone can give about investing. However, that's not something we are apologetic about-it's old because it's tried and tested and it's true.

There's very little that is really new in the world of investing. The same patterns of bull runs and bear phases reoccur, and they provoke investors to act in the same ways. Investors - sometimes new investors but very often the same people - tend to do the same things right but also commit the same mistakes.

So here we are, in the summer of the year 2006, with the Indian stock markets higher than they have ever been, and seemingly, having weathered the end of a long bull-run without falling too much. At a time like this it is difficult for an investor to figure out what to do, either with his existing investments or about fresh investments that he'd like to make. By many accounts, the markets are still going to be strong and what we are seeing today is just a temporary stop on the way to higher levels.

In all bull-runs, our instincts suggest that this could go on for a long time. Of course, rational thought suggests that it can't but then, the heady sight of the numbers in the pink papers marching ever upward banishes all rational thoughts from investors' minds.

The dilemma is self-evident, since we optimistically believe that the bull-run will go on. This suggests that we should hold on to our holdings and banish all thoughts of selling any equity assets. Selling them while the market is rising seems to be a stupid thing to do, equivalent of throwing away ready money that is there to be taken. Sometimes, we think of booking profits but while stocks are rising, the obvious thing to do is to buy even more equity assets with the profits that we have booked.

And the massive temptation to buy equity assets has been very strong over the last year. As a proof, just look at the kind of money that mutual fund IPOs have collected over this period. In just two years, 56 new equity funds have collected a massive Rs 40,250 crore. This is simply unprecedented. India's investing public has well and truly loosened its purse strings and is lavishing money on the equity markets. While data on fresh money being invested directly in stocks is hard to come by, any broker will tell you the real story.

While the wisdom, or otherwise, of investing in fresh new funds without a track record is a separate issue, the equity fund IPO boom clearly indicates that investors are unable to resist the temptations of believing that the bull run will continue. This is a mistake.

So are we saying that stock prices will fall much lower soon? No, that's not why we think this is a mistake. Stocks may not fall for years. It is possible that we could be in the middle of a historical uptrend that could see the indices double again in a few months or years. It is also possible that stock prices could either drift downwards or stay at the same level for extended periods of time. As at any other time, any investment strategy that assumes either the continued rise (or fall, for that matter) of the market is doomed to fail.

Interestingly, it is our clear perception that many more investors are following a potentially disastrous bet-everything-on-equity path than were doing so in, say, late 2003. The reason is not far to find. In those days, the memory of disastrous equity performance and great debt performance was fresh in everyone's mind. Cast your mind back to November 2003, when the Sensex had risen 58 per cent in the preceding 6 months and was already at 5044 points. At the time, income funds' recent performance was pretty good. Over the preceding year, a good medium-term income fund would have returned around 11-12 per cent.

Also, investors had sharp, relatively recent memories of the collapse of equities and of superlative performance by income funds. Today, things couldn't be more different. Investors' foremost perception is that while the Sensex has gone up from 3000 to cross 10,000, income funds have hardly gained and indeed some income funds have even lost money. To be sure, these two things haven't happened over the same time frame but the perception is that investing, from now on, is all about equity.

By any measure, an all-equity investment strategy is not a good way of going about things. Debt is a crucial part of investing. There could be long phases when the stock markets are down. In such times, it is debt that will provide stability to your portfolio. As we've always said, asset allocation is not about some hypothetical measurement of 'risk tolerance', but about matching the time horizons of your needs to the time horizon of your investments. If a certain part of your investment is for a short-term, then it must be parked in a short-term debt fund, no matter how wonderful you think equity investments are.

One crucial point is that when we say 'time-horizon' we don't so much mean the total time for which you will need to stay invested as how much notice you will get when you have to liquidate your holdings. Ideally, (although this ideal is not easy to achieve in practice), if a certain amount may be needed at a day's notice then it must be considered short-term even if that day may not come for an year or two.

Remember, the basic facts of your financial affairs don't change just because the Sensex is above 10,000--and asset allocation is not about the markets, it's about you. Therefore, do not let yourself get intoxicated by the numbers. Instead, decide on an asset allocation and stick to it. And that's the key phrase: 'stick to it'.

For the key part of having an asset allocation is to make sure that you periodically rebalance your portfolio to make sure that you do not stray too far from your targeted asset allocation. Suppose you start out by deciding that 70 per cent of your holdings should be in equity and 30 per cent in debt. After an year like the last one, it is quite possible that the continuous rise in equity prices could enhance your equity holdings to perhaps 85 per cent of your portfolio. At this point, instead of waiting for them to go up further, you should sell off some equity assets and buy into some debt funds so as to restore the balance to the original 70:30.

If you keep your equity holdings at 85 per cent, any decline in equity prices could hurt you that much more. And this is the key point - you are not only putting your portfolio back in line with what your needs are but you are also booking profits. The arithmetic of rebalancing inevitably means that you will be selling off that kind of asset in which you have made gains and that means that you will end up booking profits. This will dramatically reduce the risk of losses due to any subsequent fall.

So when do you rebalance? There are fundamentally two triggers for rebalancing--time and deviation. You must re-examine your portfolio once every fixed period--which could be a quarter, an year or even longer. If your actual asset allocation has differed from the ideal one by a certain number of percentage points, then you must restore the balance. Now, by changing the periodicity of this re-examination and by changing the deviation you are looking for, you could make a lot of difference to how much of a headache rebalancing becomes.

In our experience, a relaxed approach is much better. You don't need to look at your portfolio more than once a year and you don't need to bother about deviations smaller than around 5 per cents. While these limits may feel a little too relaxed at first glance, our research has shown that more frequent rebalancing and tighter limits do not actually lead to lower risk or higher gains. Instead they just add to your tax liability.

Tax-efficient rebalancing
Which brings us to the question of taxation. Doesn't rebalancing add to your tax liability? At first glance, it seems that it inevitably would. After all, the very idea of rebalancing is to sell off holdings that have made profits, isn't it.

Not necessarily. Of course, as things currently stand, long-term equity investments are tax free but even keeping these aside for the moment, it is possible to rebalance without a tax liability if you are making fresh investments. Basically, if you are investing regularly, you should keep a continuous eye on your investments and make fresh investments in that asset class in which you are running low. This way, you will find that your investments stay balanced, and in terms of the final impact on your portfolio value, you have achieved the exact financial equivalent of booking profits while paying less tax.

Some simple arithmetic will show you that your tax liability will get neutralised only if your fresh investments keep pace with the gains you are making. While this is unlikely to happen while the bulls are raging as they now are, it will certainly reduce the tax incidence to the minimum possible.

One rather disturbing implication of these continuous rebalancing may appear to be that you must keep constantly keep an eye on your portfolio but that is actually very easily done by using the Portfolio Checkup tool on our website, www.valueresearchonline.com. Whenever you have any investment to make, just run this tool on our website, note how much your portfolio has deviated from your goal and split your fresh investment accordingly.

At this point those of you who like to keep their life simple must be wondering if there are any simpler ways of doing all this. Yes, there are and they are called balanced funds. Balanced funds will deliver many of these features in a completely tax-efficient way.

There could be a couple of reasons why investing solely through balanced funds may not work. One is that you can't treat the debt part of your fund's holdings as a separately liquid part of your investment. This means that if your reason for keeping 30 per cent of your holdings in debt was that you may need to liquidate them at a short notice, then that is not possible in a balanced fund. For such convenience, you will need to keep the 30 per cent in a pure-debt fund and do the rebalancing yourself. Another reason why balanced funds may not fit the bill could be that you may not find a balanced fund which combines the right quality with the right balance.

The solution to both these problems is to keep a bulk of your investment in a balanced fund and keep the part needed for debt-only liquidity or achieving the right allocation in pure-equity and pure debt funds. For instance, you may find that the ideal way of achieving a 70:30 asset allocation could be to keep 50 per cent of your portfolio in a 50:50 balanced fund, another 45 per cent in a diversified equity fund and 5 per cent in an ultra-short term fund. This could give you the 70:30 balance while satisfying your need for maintaining some liquidity without having to sell long-term equity assets.

The bottom line is that no matter how you do it, do not let the market's frenzy lure you into ignoring the basic ideas of asset allocation and careful rebalancing. When the frenzy dies out, you will be much better off by having kept your cool and kept your balance.