“My friends are laughing at me!” exclaimed a frustrated Sameer. “I’m not happy with the returns on my debt portfolio. Every rupee invested in these funds has missed out on the Sensex rally.

I want a much larger exposure to equity, so please move all my money from debt to equity.”

The Sensex’s giddy 130 per cent climb from 26,000 to 60,000 has had a polarizing effect on investors. While one lot of them is fearful of the sharp climb, wants to book profits and exit equity, another lot is determined to throw caution to the winds and increase its equity exposure. Sameer is a case in point. Interestingly, the same investor wished to move his entire equity portfolio to debt to prevent further erosion when the market dropped nearly 40 per cent last year.

Loss aversion is a popular theory in behavioural economics, popularized by  psychologists Daniel Kahneman and Amos Tversky. They contend that humans are driven more by fear of losses than greed for gain. In the current market conditions, an investor’s risk tolerance is just as volatile as the markets. On a barbell that normally tilts heavily on the side of fear when markets are low and greed when markets are high, loss aversion and gain avarice weigh equally on both ends of the barbell today.

It is natural to experience the ‘fear of missing out’ when you see the safer part of your portfolio deliver 4-5 per cent returns compared to the growth portion, which may have delivered significantly more. The immediate instinct is to move debt assets to equity to participate in the rally. However, the returns on equity, though high today, revert to mean after a few years. Absolute and internal rates of return tend to be exaggerated, negatively and positively, when the holding period is short.

Apportioning a certain share of your wealth across various asset classes is commonly known as asset allocation. A good blend of equity and debt is necessary to create a portfolio that is realistic in terms of risk and return, and resilient enough to meet life’s important milestones. In an imbalanced portfolio, riskier investments with higher returns will dominate safer, lower-return investments. When your portfolio is in balance, neither type of investment has an abnormally high weightage, thereby providing you the upside during market swings and the cushion during market downturns.

The right balance between safety and growth is determined by your age, risk profile, goals, expense patterns, income, inflation, taxes, etc. Age plays an important role in determining how large the equity piece of the pie should be. On an average, markets rise more often than they fall. When you are young, you have age on your side and experience more crests than troughs in the markets. As you age, you have lesser time to see through market cycles and, hence, your portfolio tends to be more conservative.

Asset allocation feels like a terrific approach when markets are falling. You breathe a sigh of relief when you see your debt investments in the money compared to equity, which have nosedived into a swathe of red. However, when the markets are riding a bull, debt investments are the party spoilers. Investors get buoyed by the positive market sentiment and assume the equity party will last forever. They take on higher risks than they can absorb because of a mismatch between their risk appetite and risk perception. Investors forget the hard lessons of the past, where market corrections led to offloading equity and run-ups led to hoarding equity. Such behaviour is the exact opposite of what they should have done to escape the greed-led-buy and fear-led-sell behaviour.

Adequate Debt, Adequate Equity

Gains are made by buying low and selling high. Except, we don’t know when to buy low and sell high. Asset allocation gives you a potent formula that allows you to do just that. Let’s say, your target asset allocation is 50:50 between equity and debt. When markets climb, your portfolio has greater exposure to equity compared to debt. So, you shave off the portion of equity and move it to debt to rebalance. Similarly, when the markets fall, your exposure to equity diminishes. This is when you exit debt and enter equity. By following such a disciplined approach at frequent intervals, you are booking profits when the markets climb (selling high) and entering equity when the markets correct (buying low).

Having adequate debt in the portfolio provides the opportunity and the flexibility to enter equity during a correction. If all your portfolio were in equity, you would be constrained to average out your cost. Rebalancing your portfolio regularly may not allow you to buy at the lowest or sell at the highest, but is as close as you can get to consistently timing the market. Most importantly, your behaviour will not be driven by market noise, but by your own investment compass.

In The Heat Of The Moment

Just as it is important to maintain asset allocation in your portfolio, you must maintain the right balance between your emotions and intelligence. When you allow emotions to take over, you will cling on to an equity-heavy portfolio during market runs, and shy away from equity during corrections. Markets were at an all-time high in 2008 before the crash. Those who cashed out at the market highs and re-entered after the crash benefited compared to those who held on to equity. Those who exited and re-entered equity are the investors who stayed true to their asset allocation.

Investing is serious business. Your family’s most important and cherished goals depend on you making the right money decisions today and into the future. It’s a life-long journey, and you must reach those goals in a worry-free manner. If you make hasty money decisions where you lose more than you can stomach, you can wipe out years of compounded returns in a jiffy. It can bring you back to the drawing board to start your wealth creation journey all over again. When you drive decisions on the merit of asset allocation rather than asset location (where you focus more on specific schemes, products or investment avenues), you will stop worrying and start living.

This Diwali, while we celebrate the victory of good over evil, let’s also strive to conquer the battles within us. Let’s overpower the devil that chooses external noise over internal goals; ad-hoc speculation over planned investments; unpredictable outcomes over forecastable futures. The decision is yours and yours alone. So, what are you going to choose?

Priya Sunder is the Director and Co-founder of PeakAlpha Investments