To buy-and-hold or rebalance?
If market continues to move up, buy-and-hold is a good strategy; if you expect it to fall after a prolonged rise, consider rebalancing
The stock market is on a continual uptrend. Your biggest risk now is complacency. Having seen the market go up higher each time it declines, you may be tempted to hold your equity investments. It is not uncommon to see reports that suggest you would have doubled your return in less than one year if you had bought and held stocks or mutual funds. In this article, we discuss the buy-and-hold approach. As you will see, this approach presumes that you expect the market to continue its uptrend. Do you?
Volatility can spoil your returns experience. If a stock moves up 50% in one year, and then continues to go up another 20% in the next year, your two-year return will be 80%. But if the stock moves up 50% in one year and then declines 25% next year, your two-year return is only 12.5%! This leads to a simple observation. If the market continues to move up, buy-and-hold is a good strategy. But if you expect the market to decline after a prolonged rise, you should consider rebalancing your portfolio.
Of course, this is easier said than done. Many took profits and moved into cash when the Nifty Index was at 15,000 levels only to see the index scale new highs thereafter. It is, therefore, understandable if you are reluctant to take profits on your equity investments. The issue is that it is difficult to forecast a market turn. There will be always a few who will get the market turn correctly. But we may not know whose forecast will accurate till the market declines! So, it is highly likely that you may not catch the market turn. What should you do?
Rebalancing refers to annual adjustment of investments in your portfolio to align with your target allocation. Your portfolio is likely to have two asset classes — equity and bonds. You will likely invest in mutual funds for your equity allocation and in bank fixed deposits for your bond allocation.
Suppose you start a goal-based investment with 60% allocation to equity and 40% allocation to bonds. Also, suppose you expect 12% return on equity and 5% return on bonds. If the actual return is equal to your expected return, the proportion of equity in your portfolio will be 61.5% at the end of the first year. But if the actual return on equity is 25%, the weight of equity will increase to 64% because of the size of unrealised gains. This means you are exposing more of your risky investments to market risk.
You must strike a balance between letting your equity investments accumulate wealth and yet not risk too much of unrealised gains. A simple way to is to rebalance your equity investments based on the expected returns- take out excess gains over 12% (expected returns) in a year and move them to fixed deposits that pay annual interest.
If you are confident that the market will continue its uptrend, then you should hold your equity investments. But if you are nervous about losing your unrealised gains, then consider strategic rebalancing discussed above. Note that you cannot take out all your unrealised gains; for then, your equity investments may not accumulate the desired wealth at the end of the time horizon for your life goal.
True, strategic rebalancing will lead to reduced wealth accumulation compared to buy-and-hold strategy if the market continues its uptrend. But holding on to your unrealised gains for long could leave you with the anxiety of whether those gains will be wiped out. Life is full of trade-offs. Rebalancing is one such trade-off that you may have to accept.
(The author offers training programmes for individuals to manage their personal investments)