One of the serious side effects of this rat race has been that asset allocations are way out of whack. There are investors who rushed into equity and then rushed back. Moreover, since the middle of last year, small- and mid-cap stocks have performed well, always a sure sign of a wild bull run. Nothing wrong with that, that’s what small company stocks do and that’s what they do for the investor. However, this leads to many stock portfolios becoming too heavily biased towards these stocks, thereby increasing volatility and long-term risk.
At times like this, soundly rethinking your asset allocation and trying to restore it by rebalancing seems like a foolish thing to do. Indeed, asset rebalancing always involves (by definition) selling assets that have performed better and leaning towards assets that have performed worse, or at least less well. It goes against investors’ instincts, and in fact, that’s exactly why it’s often ignored until it’s too late.
For a moment, let’s recap the basic concepts here and what the logic is, in simplified terms. A: Basically, there are two main types of financial investments, stocks and fixed income securities (deposits, bonds, etc.). Two: equities have higher potential payoffs and more risk, while fixed income securities have lower but less volatile payoffs. Depending on your preferences, you should invest in stocks and fixed income securities in a certain ratio. This ratio is called asset allocation. Three: Over time, stocks and fixed incomes gain at different rates, which changes the asset allocation to what you want. Moving money between the two to restore this distribution is called asset rebalancing. The same principle can also apply to different subtypes within assets. For example, within stocks, small, mid, large caps or even sectors.
Bullish stock market making you invest in these overpriced stocks? You should sell them instead…
Some stocks have very high valuations
Thanks to a cash laden stock market, Sensex hit a new high touching the 60,000 mark. continues against covid-19 and pandemic-induced economic weakness. As of September 21, 2021, Sensex closed at 59,000, 41% higher than its pre-covid peak of 41,953 on January 14, 2020.
Here’s why it works and why investors are so hesitant about the idea. When ‘A’ grows faster than ‘B’, you periodically sell ‘A’ investments and invest the money in ‘B’ so that equilibrium is restored. When ‘A’ starts to lag, you periodically sell some of your ‘B’ and move it to ‘A’. This beautifully implements the basic idea of making profits and investing in the downed asset. Inevitably, things revert to the mean, and that means when one starts to lag, you’ve pulled some of your profit into the other. Replace A and B with any asset class or subclass, the principle is the same. Obviously this is a difficult thing to do. Asset rebalancing always involves, without fail, abandoning the very type of investment that is doing well.
However, investing success is full of hard things to do, in the sense that they are psychologically counter-intuitive. Most investors learn their lesson after a few bad experiences. The lucky ones get there without too much expense.
(The author is CEO, Value Research)
Also read: It’s time to rebalance your portfolio now