Portfolio Ideas: Why buy-and-hold could be risky

The Nifty 50 Index has risen 20 per cent in about five months. That is a handsome gain for an index consisting of 50 diversified stocks. Whether you believe in Newtonian Physics or plain logic, you realise that “what goes up must come down”. The question is: What will you do when the market eventually claws back your gains? Will you hold on to your equity investments on the pretext that you are a long-term investor? Or will you sell and minimise your losses (or loss of profits)? In this article, we discuss what you should do so that a market downturn does not have a significant adverse effect on your life goals.

If you read personal finance articles, you will find that the authors typically want you to stay invested in the market even during its downturn. Their argument is two-fold. For one, the market typically moves up after a sharp downturn. So, why bother about short-term declines when you are in for the long haul? For another, you may not know when the market will move up. So, there is a good possibility that you may fail to get back into the market at the right time.

We agree with the second viewpoint. Consistently timing the market is, indeed, difficult. We, however, differ with the first viewpoint. When the market declines, your portfolio’s notional value reduces. And when the market moves up again, your investment portfolio has to move up from this lower value. Suppose your portfolio value is ₹10 lakh. A 15 per cent decline in the market brings your portfolio value down to ₹8.5 lakh. But when the market goes up 15 per cent thereafter, your portfolio will not head back to ₹10 lakh, but to only ₹9.8 lakh. As your investment capital increases, the shortfall widens.

This is called asymmetric returns effect. It takes a lot of effort for you to recover not just losses, but notional losses too. But it takes smaller effort for the market to wipe out your notional gains. Suppose your portfolio gained 20 per cent in the last five months to accumulate ₹10 lakh. It only takes a 17 per cent decline in the market to erase these accumulated gains.

That is why you should act when the market declines. But you should not act in haste. Remember, your decisions are bound to be wrong when you are stressed. It is better to have a pre-determined rule to protect your portfolio from a downturn. But have someone in your family execute this rule for you when the need arises.

Here is what you should do. Calculate the return that you need on your investments to achieve a life goal. Suppose you need 9 per cent compounded annual post-tax returns to make down payment for a house 10 years hence. Based on your returns expectations on equity and bonds, you can arrive at an asset allocation that will enable you achieve this required rate.

Now, review your portfolio every year. If the unrealised gains are more than 9 per cent in any year, you should protect your excess portfolio value from asymmetric returns effect by selling some of your equity investments. Your objective is to have just enough equity in your portfolio, which when combined with your bonds, will earn an expected return of 9 per cent the next year.

Besides your annual review, you should apply this rule when you are anxious that a sharp downturn in the market can have a significant adverse effect on your portfolio. Just holding on to your unrealised gains in the pretext of being a long-term investor will not help. You do not have to fight or flight the market. You just have to rebalance your portfolio based on a pre-determined rule.

The writer is the founder of Navera Consulting. Send your queries to portfolioideas@thehindu.co.in