It is the very characteristic of the securities markets to swing from one end to the other depending on the popular mood and in such times, those who can separate reason from emotion can spot opportunities.
As Sir John Templeton puts it, "To buy when others are despondently selling and sell when others are avidly buying requires the greatest fortitude and pays the greatest potential reward."
But how does one act contrarian? There is an adage in the stock markets, "Do not catch a falling knife."
Well, there is an answer in one of the proven portfolio investment strategies - Asset Allocation. What is asset allocation? How does it work? How does it help an investor invest contrary to the market?
Asset allocation is the scientific process of dividing all your money across various non-correlated asset classes. In simple terms, if your money is allocated between stocks (equity shares or growth mutual funds), bonds (debentures, government securities, long term fixed deposits or income funds) and cash (savings bank account, short term bank deposits of money market mutual funds), you have taken the first step.
One may consider various other investment options like property or gold, but we will restrict our discussion only to the financial assets, which are stocks, debentures and cash.
The second step is to know how much money should be allocated in which of the options. Now this is a function of two things, the investment options have certain traits or characteristics and the investor has certain financial goals as well as certain risk appetite.
This risk appetite is again a function of one's needs as well as psychological ability to handle the unexpected. The science of asset allocation tries to build a portfolio that matches the traits of the assets with the needs of the investor.
There are various approaches adopted by different advisors to build portfolios for their clients largely keeping the clients' needs in mind. We will not get into the discussion of the same here since the solutions would be different for different investors since their needs would be different from one another.
Let us come back to the discussion of what asset allocation can do and how it can help investors. We will try to keep it very simple only for the purpose of understanding. The actual portfolios or the practical approach cannot be so simple.
Let us assume that after assessing the needs of one of the clients, the advisor recommends investment of 50% of the assets in an equity mutual fund and 50% in a money market mutual fund.
The investor and the advisor then decide to review the performance of the portfolio every six months. The review process is also very simple. The objective would be to maintain the allocation between equity fund and money market fund at 50:50.
Given that the stock prices are volatile over shorter terms and move in line with the profits of the company over longer periods, we are likely to see the value of the equity mutual fund go up and down over time. When that happens, the asset allocation would stray from the 50:50 that was set originally.
When the equity prices move up faster than the debt prices, the allocation will get skewed in favour of equity and our review process would restore it back to 50:50 by shifting some money from equity fund to debt fund. In the other case, when the equity prices move adversely, the balance would get skewed towards debt and the balance can be restored by shifting from debt fund to equity funds.
What you are doing here is selling equity when the prices run up and buying when the units got cheaper. One is able to do this without having to worry about analyzing what is happening in the market place.
The above example is applicable to an investor, who has a static portfolio without any additions into the portfolio or withdrawals from the same.
In reality, the investor may get inflows, which need to be invested in the portfolio or have a need to take some money out of the investments. In such cases, at the time of investment or redemption, the investor has to look at the current market value of the equity fund and debt fund and rebalance the portfolio to 50:50.
Automatically, the money goes into equity fund when the stock prices are low and into debt fund when the stock prices are high.
The only problem with the above is that what looks so simple is very difficult to execute since the approach means ignoring all the sound bytes taking place around you. It takes a lot of courage to chart one's own course and more importantly, to continue walking that path at times, all alone.
The author works with a leading mutual fund company. The views expressed are his personal views.
For more on mutual funds, log on to www.easymf.com
