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Sinking markets? Move money from debt to equity

Suresh Sadagopan in Mumbai | December 22, 2008 13:40 IST

In a falling market, move money from debt to equity. Surprised? Read on . . .

Most investors have this uncanny habit of going the whole hog. That is, when they are buying equities, they put most of their savings in them. But as soon as the tide turns, they rush to debt.

Since the stock market started slipping in January, many investors have consciously moved money from stocks to safer debt instruments and, in many cases, at significant losses. The reason: They want to cut the losses.

While the safety in debt is not questionable, an investor should ask himself -- why do I need to move now? Logically, we all know that buy low, sell high is the basic dictum of investing in stocks.

Yet, most investors do not follow this. Buying is done when the market is on an upswing. Many even borrow to invest in stocks.

But when the markets fall sharply and valuations have actually turned attractive, there is a total lack of investor interest.

That's the reason financial planners' advice that there should be proper asset allocation. This basically means that there should be a balance between debt and equity that needs to be maintained at all times.

While going for asset allocation, the basic thumb rule to follow is 100 minus the age should be the percentage in equities.

However, in reality, this depends on a whole lot of other things like number of dependents, risk appetite, years to retirement, among others. Accordingly, a proper asset allocation needs to be done.

Of course, this will change from time to time, depending on changing circumstances.

But the main point is that once you have done asset allocation, it is important to stick to it. Even if market realities have changed, you should maintain this asset allocation.

Let us understand this with an example. Ravi Sinha is an investor, who is about 45 years old.

He is expected to work till 60. Since he has about 15 years to go, his financial adviser has advocated a 60 per cent allocation in equity and 40 per cent in debt.

In the last several months, Sinha's equity allocation value has come down due to the market meltdown.

As a result, the equities portion in his portfolio allocation is down to 40 per cent.  According to the asset-allocation principle, it  needs to be brought back to 60 per cent.

But how does he get the money? Sinha, in this case, has to route money from debt to equity. This makes sense because prices are low now. Take Sinha's case, whose portfolio was worth Rs 500,000, with Rs 300,000 in equities (60 per cent) and Rs 200,000 in debt (40 per cent).

Say, due to the erosion in the equity value, today his portfolio is worth Rs 4,50,000, with Rs 200,000 in equities and 2,50,000 in debt. His asset allocation has now changed to 55 per cent in debt and 45 per cent in equities.

To maintain the asset allocation at 60:40, he has to move Rs 70,000 from debt into equity. So Rs 2,70,000 in equity and Rs 1,80,000 in debt brings back the balance.

Sounds easy?

But it is rather difficult to convince any investor that this is the best way to manage funds.

They worry that they would lose more if the market goes down further. True, but investment is about making money in the long term. And by long term, we mean a good 5-10 years.

It is not that only debt money has to be shifted to equity. Even in times of a boom, go for asset reallocation. Taking the same example, if Sinha's portfolio goes up to Rs 600,000, with equity at Rs 4,50,000 and debt at Rs 1,50,000, the asset allocation has changed to 75:25 in favour of equity.

In this case, move Rs 90,000 from equity to debt. The new portfolio will have Rs 3,60,000 in equity and Rs 2,40,000 in debt.

Again, it is very difficult for an investor, who is making money in equities, to move money to debt. But over time, this is what works the best for him. 

Making such corrections also takes care of an important aspect -- there is no risk of timing the market. Of course, it is important to remember that such asset reallocation should be done only once or twice a year, at best.

The writer is director, Ladder7 Financial Advisors

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