The share markets are hovering near all-time highs. Equity investments have done exceptionally well in the last couple of years, resulting in phenomenal growth in investment portfolios.
But unbridled optimism during such bull runs can spell trouble for investors. Here is an effective strategy followed by prudent investors to manage investments during euphoric markets.
Bull Markets Can Cloud Judgement and Increase Risks
There is no denying that bull runs create wealth for investors as the value of assets in their portfolios swell. But heady optimism during such times impacts investing judgement.
The rapid rise in stock prices excites investors, and greed sets in. The fear of missing out prompts investors to throw caution to the wind as they get pulled into the euphoria.
This irrational exuberance results in investors abandoning disciplined investing principles. They end up taking far more risks than they normally would. Portfolios start skewing heavily towards overvalued stocks. Investors compromise asset allocation and start chasing momentum stocks without regard to valuations.
Such uncontrolled risk-taking during bubbly markets can be dangerous. When the bubble eventually bursts, overloaded portfolios are stuck with significant losses difficult to recoup even over long periods. We saw this during the dotcom crash of 2000 and the global financial crisis of 2008.
Smart Investors Use Asset Allocation and Rebalancing to Manage Risks
Seasoned investors avoid such value-destructive behavior during bull runs by adhering to asset allocation and portfolio rebalancing.
Asset allocation involves deciding how much of your investment portfolio gets allocated to different asset classes like equity, debt, gold etc. based on your financial goals, time horizon and risk tolerance. This results in a diversified portfolio aligned to your needs rather than chasing what’s hot.
Rebalancing means periodically resetting your portfolio back to the original asset allocation when market movements skew it away. For instance, if equities have done very well, their portfolio allocation will rise rapidly. By rebalancing, you will sell the overweight equities and buy underweight assets like debt to get the allocation back to the initial levels.
Here’s Why Rebalancing Is an Effective Risk Management Tool
Rebalancing not only maintains portfolio diversification, but has other critical benefits from a risk management perspective:
1. It forces you to book profits: When particular assets like equities become significantly overweight due to a bull run, rebalancing requires you to pare them down by selling. This ensures you actually encash some profits.
2. Buy low, sell high: Rebalancing also means buying more of the underperforming assets whose allocation has gone down. This instills the discipline to buy low and sell high rather than get carried away in irrational exuberance.
3. Controls emotions and governance: Periodic rebalancing imposes investing discipline and governance since actions are rule-based rather than based on emotions. This prevents disastrous investment decisions made in the heat of bull runs.
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When and How Frequently Should You Rebalance?
- Most experts suggest rebalancing at least once every 6-12 months. Better to review allocations quarterly even if actual rebalancing is less frequent.
- Don’t rebalance for minor fluctuations. Allow 5-10% deviation from target allocation before rebalancing. Else transaction costs may eat returns.
- Consider rebalancing when adding new money rather than selling overweight assets. This avoids capital gain taxes.