Re-allocation strategy key to pare down impending risk to portfolio
What’s on every investor’s mind is about where from now for the stock markets? The tremendous bull-run has left everyone surprised; some pleasantly and a few shockingly.
What's on every investor's mind is about where from now for the stock markets? The tremendous bull-run has left everyone surprised; some pleasantly and a few shockingly. Many couldn't believe the rapid ascent at the beginning, but made amends and we could witness the unprecedented retail participation. What flummoxed the others is the divergence of the equity markets with respect to the actual economy and more importantly the pain due to the pandemic. This was clear when the markets seemed perturbed even as the second wave was devastating the country.
Of course, I've used this space earlier to elaborate on why the markets behaved as they did, but it's also said that markets don't correct/fall for the same reason twice. If the worst of the pandemic in terms of economic sanctions that brought us during the initial phase through lockdowns, etc., have been ruled out, the equity markets wouldn't possibly discount another wave or waves going forward, as the worst-case scenario was already priced-in. From now, pricing or estimates move on how quickly the economy gets back to pre-pandemic levels and beyond in terms of growth, etc.
Going back to the initial question of what's next, it's anybody guess, but let's see what could be done from the investor's point of view. While we remain fascinated about forecasting or predicting the future, the central question hovers around how we protect the portfolio or investment from an untoward risk.
Going back a little over a year, in March, assuming an investor did nothing to their portfolio, it would've mostly come back and thrived past the earlier levels. Of course, only if one is invested in the broader market index, have prospered but if they were to allocate in sectors like aviation, hospitality, etc., would've languished still. If one were to stretch the timelines further back into the past, the markets have recovered from even the Great Financial Crisis of 2008, though taken about a few years' time. Now, should we do nothing at all with the portfolio is the question. While diversification is one way to reduce risk, the other is through rebalancing the portfolio. Rebalancing allows one to assess if a particular stock or an asset is at a higher weightage or too concentrated.
However, it could be a reactionary strategy or acted due to the changing external market scenarios. Diversification helps in approximating the possible risks in advance and thus helping the investor estimate the risk to return. Reallocation is more like a reactionary adjustment of an existing portfolio during volatile markets. It could be done even when there is a overheating of a stock which overshadows or grows overweight from the standard defined in the portfolio construct. In a raging bull market or even when a particular sector(s) does well, inflating the price of the participating assets, it could upset the overall portfolio diversification and proportion. At those situations, the investor or the fund manager could shave off the extra weight, deviation from norm, so that the gains are reallocated. Reallocation not only reduces risk, but could add zing to the portfolio when invested with a tactical outlook. This could, at times, backfire as the reallocated asset underperforms than the principal allocation from where it was dwelled. But that's the cost of reducing the over concentration or the dilution of returns to protect against an impending risk. These cost are indirect that could be an error of omission. For the investors the risk mitigation, thus, comes at a cost of underperformance in their portfolio.
In conclusion, investors must be wary upon their risk tolerance, while keeping a tab on their timelines with the changing markets. Ideally, they diversify the allocation so that they experience a better risk adjusted returns, but could use the reallocation strategy to pare down an impending risk to the portfolio. However, investors who're clearer about their risk and having an extended timelines could benefit to stay invested all through the cycles in the market.
(The author is a co-founder of Wealocity, a wealth management firm and could be reached at [email protected])