The rather simple answer to this question is “Do absolutely nothing”. The same is true whether stock prices are falling or the market is erratically moving.
Of all, you’re a mutual fund investor, not a stock trader. You pay a partial sum of money to the fund company as costs, notably for managing your money. If you have to worry about what the markets have been doing and how you need to modify your investments accordingly, then why would you give the cost to your fund manager to manage your money? Hence, the first and foremost point that you need to keep in your mind is that ‘Investing in mutual funds eliminates the need to worry about the stock market’.
I believe that we do not live in an ideal environment, thus we may not overlook market highs and lows. However, if you take some care in selecting and tracking your mutual fund investments, as well as adjusting them to market situations, you may live in an almost-perfect world, at least in terms of mutual fund investments.
Investors are often anxious about how much the market may collapse. However, as the market reaches new all-time highs, we worry if the rally will continue or if it will reverse from here. As a result, our worry remains unchanged, regardless of market fluctuations.
How to find out if the markets overvalued?
The standard approach to address this question is to look at various valuation measures, such as the Sensex’s price to earnings (P/E), price to book (P/B), and dividend yield. If the benchmark index’s current P/E, P/B, or other ratios exceed their 10-year medians, we may conclude that the markets are overvalued. However, market valuations are a complicated affair. The investor determines the cost of valuations, just as beauty is determined by the beholder’s perception. The market may appear pricey to one investor, yet favourable to another depending on what is being considered. Furthermore, the aforementioned metrics or ratios serve as fundamental valuation tools. There are several ways to look at valuations, and they may all be pointing in opposite orientations simultaneously.
Valuations are based on future profits potential. So, high valuation might indicate optimism about a country’s or market’s potential. Broad-based valuation figures might sometimes be deceptive. When tracking the value of markets, keep in mind that they are the product of the underlying constituent valuations. For example, the Sensex has 30 stocks. Its total values are a weighted average of the individual valuations of the underlying 30 stocks. Evidently, not every stock would be pricey. Not everything would be affordable. That is why veteran stock investors frequently overlook wider market prices and look for bargains in a variety of sectors in the stock market.
Advantage of a mutual fund investor:
Mutual fund investors should not be worried about market conditions or valuations. Your responsibility as a fund investor is to stay focused on your objective and continue investing towards it. If you have been investing for retirement, your child’s higher education, or another long-term objective, simply disregard market fluctuations and continue with SIPs in your preferred mutual fund. Keep in mind that as a mutual fund investor, you have entrusted the fund management to choose stocks for you. Thus, it is your fund manager’s responsibility, not yours, to take care of the portfolio’s valuations. He would sell/reduce shares in overpriced stocks while buying/increasing holdings in cheap ones. He may also opt to enhance the cash levels or liquidity in the portfolio if he believes that there are few chances at this moment. (As the fund manager of Warren Buffett’s Berkshire Hathaway would have thought – as on date of writing of this blog Berkshire is sitting on whooping cash of $155 billion on its balance sheet).
Some of the basic mistakes that mutual fund investors tend to commit:
When the market rallies, many fund investors halt their SIPs and make new investments. They believe it is prudent to patiently wait for a market correction or cheaper prices before making investments. This ultimately proves to be an expensive mistake for a variety of reasons:
- The timing of market corrections and bull runs is uncertain. Markets can have an upward tilt for years, with small periods of correction, so the best thing an investor can do is to continue to invest and stay engaged.
- Trying to time the market makes re-entry nearly hard. If the markets continue to climb, re-entry will be tough. If the markets correct, you might consider waiting because further corrections might be on the way. This makes attempting to timing the market a sure-shot recipe for disaster and uncertainty.
- Sitting on the sidelines during a market boom might result in missed opportunities. The cost of losing out on the finest days is far more than we can imagine. For instance, if you had invested Rs. 1 Lakh in Sensex benchmark tracking fund some 15 years ago, the current value of it would have been Rs. 3.75 lakhs. But if you had missed the 10 best days in these 15 years, your corpus would have reduced to Rs. 1.6 lakhs and if you had missed the best 20 days of the market in these 15 years of your investment, then the corpus would have in fact shrunk to Rs. 92k. It shows what difference missing the best days in the market can have on your overall corpus.
- Markets may remain inflated for a long time, even if you are correct about their overvaluations. Let us consider this example: Sensex was around 47k in December 2020, which was its all-time high. The in Dec-2021, it was in 58k, which was its new all-time high. But now in Dec-2023, it was at its all-time high of 72k. At all highs, it looked expensive, but then it stayed so for such a long period. What if you had stayed out of the market all this while when the Sensex rose almost 53% in a span of just 3 years?
Now, back again to the topic, the fund investors should have a simple approach and stay balanced throughout their investment journey:
Asset allocation and regular rebalancing are the most effective strategies for mutual fund investors in both bull and downturn markets. The very first step you should do if you haven’t already is choose your target asset allocation. Asset allocation is the proportion of stock and debt in your portfolio. Indeed, some investors may opt to include gold/silver or another asset class in this mix, but for the majority, dividing the corpus between equities and debt is adequate. Equity and debt are inherently contrasting asset types. While stock often delivers higher returns in the long run, it is more volatile in the near term. Debt returns are typically lower to moderate, but they are more consistent and less fluctuating. As a result, stock and debt are the fundamental components of every asset allocation strategy in mutual fund investing.
According to your risk tolerance, goals, and age, you may select an asset allocation mix. Most working-age persons can benefit from a normal 75 percent equity and 25 percent debt allocation. As you approach retirement, you may decide to make it 50:50 or even 25:75, but don’t lower equity too much because equity is what provides you with inflation-adjusted returns in the long run.
Bull markets are an excellent opportunity to make your mutual fund investment portfolio sleek and sharp. Maintain your asset allocation. Don’t mess with it merely because the markets have shifted. Keep in mind that your asset allocation is your greatest defence against market fluctuations.
After determining your asset allocation, you just need to rebalance your investment portfolio from time to time. As time passes, our portfolios get overloaded with funds. Regularly rebalance your portfolio. For example, if you intended for a 75:25 stock-debt mix and the equity portion has increased to 80 percent as a result of the market’s bull-run, you can sell 5% of your equity and acquire debt funds. On the other hand, you can also move your fresh investment flows to debt, restoring the right asset allocation. This effectively takes care of the booking of profits in inflated markets. During a bear run, you would do the reverse. This would hence allow you to purchase equities when it is undervalued.
Readjusting your portfolio by selling a portion of the overpriced asset may also result in a tax on the profits. To prevent this, as previously stated, you can employ the additional investment flows to the undervalued asset type to re-establish asset allocation. Also, rebalance the asset allocation only when your intended levels have been clearly violated, say by 5-10%. Do not do the rebalancing for slight variances. Stock markets are prone to fluctuations of a few percentage points. If you find it difficult to alter your allocations, consider hybrid funds. Hybrid funds have specific proportions to equity and debt, and they do not have to pay taxes when they purchase and sell to change their allocation. So, making investments in them not only eliminates the need for regular rebalancing, but it also provides tax advantages.
Choose the appropriate assets based on the time frame for your goals. For goals that are longer than five years away, go for equity investments. For individuals who are three to five years away, equity-savings funds are appropriate. Short-term debt funds or liquid funds are ideal for goals that are less than three years away. Avoid making investments in equities if you need your corpus in the short-term.
Some of the cautionary points to take care of:
- Refrain from investing in sectoral/thematic funds or high-performing funds with specific objectives. Certain themes/sectors may appear to be doing well at times, but when the trend turns, such funds suffer as well.
- Minimize exposure to mid- and small-cap funds. During bull runs, this market category often performs well. However, it is more volatile and risky. Investors with a higher risk tolerance can invest a portion of their assets in these funds. For the others who are risk averse, a mix of flexi-cap funds, large-cap funds, and index funds is sufficient.
- If your long-term financial objective is due in fewer than five years, avoid riding the equity market rise. Instead, focus on the amount needed for your goal and start withdrawing from the market using a systematic withdrawal plan (SWP).
- Refrain from focusing on market news and TV debates on stock markets. Realize that the market and economy are always changing. Nobody can predict with precision where the market will go.
- Invest in stocks only if you have time to conduct thorough study. Avoid acting on advice or on trading derivatives (futures and options). Recognize that long-term investing in reliable equity funds is the simplest and most successful approach for retail investors to accumulate wealth. Hence try to stick to that path of wealth creation.
Conclusion:
Stick to the established principles of diversification, long-term planning, and focused investment. Remember that nothing happens for you simply because the market has reached an all-time high. Over the previous ten years, the Sensex has reached new highs 232 times, or once in every 16 days (on an average). So, you should have worried 232 times in the last ten years, which is a lot to ask when you have other productive tasks to accomplish and celebrate in your life.
