The old adage of not putting your eggs in one basket rings especially true during times when markets are at a peak, and valuations frothy. When it comes to investment, you can deploy the tried and tested technique of rebalancing your portfolio to diversify your risk and guard against wild swings in the market.
The term itself is called asset allocation, and it should be a periodic exercise based on the market’s performance. This will work to your financial advantage in the long term.
Equity vs Fixed Income
By its very nature, equity offers a chance of high return at a high risk, whereas fixed income instruments are used to accumulate lower but steady gains.
Based on your financial goals and risk appetite, you should be investing in these two asset classes in a pre-decided proportion. This is called asset allocation, and the process by which you shift money between the two based on the progress of the market is called asset rebalancing.
Riding on Equity and Debt
There are several times during a market cycle where equity grows quicker than fixed income instruments, just like the red-hot market of today. The best way to protect and take advantage of your gains after the market has seemingly reached a summit is to shift money away from equity toward the debt component of your portfolio to restore your prior asset allocation. This also helps realize your gains from the equity market, shielding it from a potential downturn in the near term.
Conversely, there are times – especially during or after a market fall – when equity underperforms its debt counterparts and often by a hefty margin. Those are occasions when you should periodically look to make the switch to equity.
Guard Against Volatility
Inevitably, the market tends to return to its mean over time and this is when the technique of asset allocation would have helped you reap dividends. Volatility is inevitably diluted, and returns would not have taken much of a dent.
In theory, this might sound like a difficult task to implement. However, it isn’t and with time, it can be inculcated as a healthy habit. There are also several asset allocation funds available in the market which follow various models to arrive at their specified asset allocation ratio and can potentially be useful for a new investor.
(The writer is CEO, BankBazaar.com)