A classic passive investor makes systematic investment plans (SIPs) to buy mutual funds (usually index mutuals) at regular intervals. This method eliminates (almost) all discretion and avoids some behavioural difficulties.
The key factor is that this is a mechanical process; once the initial decision to do an SIP is taken, the investor can "fire and forget". He does not have to think about the pros and cons every time money moves from his account into equities. It imposes discipline; some savings will be parked every month. There will always be some returns, even if those are not earthshaking. In addition, the temptation to time the markets is removed.
Read more from our special coverage on "MARKET INSIGHT"
But, in the broader context of asset allocation, the systematic investor must also review and rebalance his or her portfolio every so often. Any portfolio should include a judicious mix of standard assets like equity, debt, real estate, bullion, etc. The weights of different assets should remain within certain bands. Debt and equity are the most easily fungible of assets and there are times when the investor should invest more in debt and times when she should invest more in equity. If a equity portfolio has given strong returns for some time, there will be a case for reducing equity exposure because the allocation will be overweight. Vice versa, if the stock market has been weak for some time, there will be a case for increasing exposure since the equity exposure will be underweight.
There are other situations when equity exposure could be increased. For example, a broad pattern of higher earnings growth, or a trend of lower interest rates could be a trigger for increasing equity allocation. How does an investor do such a rebalancing, without breaking the SIP discipline, or falling prey to the temptation of timing? The key once again is to set mechanical rules. Work out the situations when rebalancing will be required beforehand and stick to those.
Typically, let's say the systematic investor wants to increase equity exposure in a falling market. If a market has fallen significantly, increased equity exposure will average the cost of acquisition down. Another situation where increased equity exposure is tempting is a market where growth seems to be accelerating. In this case, there will be higher earnings visibility or strong growth in revenues. Lower interest rates could also be a trigger for higher equity exposure.
All these situations can be diagnosed mechanically. The falling market is most obvious. But, earnings visibility, revenue growth and lower interest rates also show up clearly. What is more, rules can be generated to invest mechanically in such situations.
The investor can increase exposure by graded responses. Say, she reviews the asset allocation every six months. The base level commitment to the SIP is always maintained. But, a mechanical formula can be worked out to increase commitments in a falling market. If the market has fallen 10 per cent, for example, the SIP exposure may be increased five per cent per month over the base commitment; if the market falls 20 per cent, the SIP may be raised 10 per cent/month. Similarly, if the earnings growth rate has improved or interest rates have been cut, formulae may be set up.
What the trigger point should be; how much to increase SIP commitment; what the respective allocation weights for every asset class should be; all these are up to the individual's discretion. If these things are worked out in advance, decisions can be taken coolly and mechanically.
There is a good case for increasing equity commitment now. The market was bearish through March 2015-February 2016 and lost roughly 25 per cent. The post-Budget recovery still leaves it 15 per cent below the March 2015 peak. So, the logic for increasing commitments due to a fallen market exists.
There are also some signs of early earnings recovery. Last fiscal was horrible but it could have been the bottom of the economic cycle. If the monsoon is reasonable, there will be a consumption spurt. Lower policy interest rates should also transmit through into the commercial system now and that will surely help highly indebted companies and could lead to better equity valuations. All this should mean a continuing cyclical rally under most circumstances.
The economy could disappoint if the monsoon doesn't oblige, or the global economy goes bust or the government misses its deficit targets. But, if everything goes according to plan, a rebalancing in favour of greater equity exposure will lead to increased returns down the line.
