We recently received a query from one of our clients regarding management of volatility in a portfolio. Many are of the opinion that timing the market by way of constantly switching between equity and debt depending on market fluctuations may be the best way to counter volatility. We are reproducing below our reply capturing our thoughts on this subject which we think others may find useful as well:
This is with reference to your query regarding management of volatility in the portfolio. Before I can answer your query, I deem it fit to dwell a bit on the mind-set one must have to invest in the equity markets. Below are my thoughts on this subject:
Timing the equity markets
Although timing the markets by way of investing at bottoms and taking money out at tops sounds good in theory, it is extremely difficult to implement in practice, even for the best of professionals. If history is any proof, money has been made in the stock market on a sustained basis only by remaining in the market for long periods of time and investing in good quality companies and not by timing the market. Retail investors who cannot spare the time in evaluating companies are better of investing regularly through mutual funds/ portfolio managers and leave the task of finding companies in which to invest to their judgment. As retail investors, one should spend time in identifying the right fund class, manager and other such criteria when investing.
Coming back, extreme patience and a long time horizon (at least 5 years and ideally, minimum 10 years) are the attributes one must have in order to earn superior returns in the equity market. One should not worry about the day-to-day fluctuations of his/her investments. Once there is clarity about the investment time horizon, it becomes a lot easier to handle volatility in equity investments. The return that you get at the end of your investment horizon is what matters. Any interim volatility is of little significance.
Hidden costs associated with regular switching
Another reason why market timing/ constantly switching between equity and debt does not work are the hidden costs associated with switching. These are not mentioned in your statement but every time you switch, there is a cost attached to it which eats away your returns.
How volatility may be managed to protect returns
Given the above, we are of view that switching constantly between equity and debt may not be the best way to manage volatility in a portfolio. Rather, volatility should be managed by matching your investment time horizon with an appropriate investment class (equity, debt, etc.). This should form the basis of deciding the suitable asset allocation and managing risk. In the plans suggested by us, different allocation between equity and debt is suggested for (a) a 5-year investment horizon, and (b) a 10-year investment horizon.
Further, in each plan, funds are shifted from a volatile investment class (equity) to a relatively safer investment class (debt) as and when the time to goal approaches. To give you an idea, this approach is illustrated in the table below:
Year Exposure to Equity (in %) Exposure to Debt (in %) 1 – 4 100 0 5 – 7 50 50 8-9 25 75 Year 10 0 100
Just to summarize, in my view, so long you invest in an asset class which matches with your goals and aspirations, temporary fluctuations in its prices should not be a concern.