How and when must you re-allocate

A successful self trader – Rule # 31

This is an extremely critical decision as it can have fairly huge opportunity costs. When to get out of certain sectors or certain themes is an important decision. Also the decision on whether to be in equities or debt is a very fundamental decision. There are variety of reasons you should look at re-allocation like change in macros, too much focus on a few sectors and new emerging opportunities. Read and apply!

 Exit is equally important; perhaps more

Back in 2005, when the markets had crossed their previous 2000 highs, an investor came up and wanted to exit equities altogether. His justification was that a new high cannot be sustained. Back then the Sensex was at 6400. I only wonder what he eventually did, because the Sensex actually appreciated 250% from those levels. Classic re-allocation fallacy!

I am sure his case is not a case in isolation. Many investors take these important decisions without adequate logic, justification, reasoning and forethought. While in many cases, re-allocation can be a personal decision, a well chalked out re-allocation strategy can go a long way in reducing pain as in the above case. Here are a few basic pointers on how to design a re-allocation strategy. Check it!

Asset re-allocation cannot be a routine activity. It has to have a set of pre-determined triggers for implementation. You need to realize that your best thought out strategies can become obsolete with the passage of time. You must also be dispassionate enough to let go of your strategies or stocks that have served you well for a long time. That is the core of asset re-allocation.

3 common reasons for asset re-allocation

You are overexposed to a particular story

It could be a sectoral story or a theme story. Any situation where a concentration on industries, dividends yields, mid-caps etc increases your concentration risk, it is a classic case for you to re-allocate your portfolio. It is a trigger!

Global or domestic macros have changed

Classic cases: Oil prices have crashed and you are exposed to drillers; China is slowing and you are focused on metals; RBI is planning to raise rates and you are overexposed to rate-sensitive stocks like auto, banks and real estate.

You are defensive in a raging bull market, or vice versa

If the first two were cases of passive re-allocation, this is a case of active re-allocation. Be in large caps when markets are fairly valued and be in mid caps when markets are undervalued.

“Be it stocks or bonds, an investor must always rebalance and go where the future growth is more likely” – Bill Gross

6 practical ways to re-allocate your assets

  1. Watch out for valuations of the index. This is an age-old but tested rule. Believe me, it always works. For a growing economy like India, be an aggressive buyer at around 12 times P/E and be an aggressive seller above 25 P/E. You may not catch tops and bottoms, but why waste precious money on euphoria
  2. Watch out which way the retail investors are going. They normally tend to flock in hordes at the top of the market and stay absolutely shy at bottoms. Bull markets are normally built on skepticism; especially retail scepticism. This is the time to undertake a serious re-allocation of your assets.
  3. Follow the famous 5% rule. Well, this is how it works. Assume you have a 40% allocation to equities and 30% to bonds. If your equity appreciation takes it to 45% or interest rates take bonds to 35%, it is the time to revert back to your original allocation. This is a rule that works for most passive investors.
  4. Always worry about the cost of rebalancing. There are two aspects to it. Firstly, there is a transaction cost and statutory charges to be paid for every sale and purchase. Also there are short term gain tax implications. Be convinced that the benefits of rebalancing will outweigh the transaction and tax costs.
  5. Ensure that rebalancing does not increase your correlation risk. Having all assets that move in tandem is not a great idea. It inordinately increases the risk of any sudden market movement. There are rare occasions like 2008 when all assets move in tandem. That was an exception, but otherwise you must be prepared.
  6. Decide the right periodicity of re-allocation for yourself. Normally an overall re-allocation in 2 years is good enough. Within that, you can do minor tweaking on specific macro events. Avoid re-allocating too often. It only adds to your cost and effort, without any commensurate benefit accruing to you!

Re-allocating your portfolio in the current scenario

The Indian market throws up a plethora of challenges. Firstly, markets are at a trailing valuation of 24.5 times. That is way above historic averages. At the same time, valuations and volatility are way below historic peaks we saw in 2000, 2008 and 2010. Also, retail euphoria is still missing. In relative terms, India still looks like a better growth story compared to other emerging market peers. So how does it define strategy?

One of the obvious outcomes of a scenario of falling rates, falling inflation, falling deficit and rising growth may be that equities will continue to outperform as an asset class. The focus will however be less on high beta stocks and more on a mix of defensives and long term growth stories. While mid-cap may still add value to the portfolio, they should be kept at a bare minimum. Remember, too much liquidity causes equity asset inflation and normally it is only the large caps that benefit.

Takeaways from the “when to re-allocate” debate

A decision to re-allocate can be either passive or active. A passive re-allocation, at best, protects your capital and helps you to outperform the index. But great ideas and great investments are normally the outcome of active re-allocation. The way Stanley Druckenmiller bet 14% of capital on shorting the pound in 1992. The way Paul Tudor Jones bet a big whale on a market correction in 1987. Or the way John Paulson bet almost everything shorting subprime mortgages in 2007. It surely paid off!

Some of these re-allocations have been mighty profitable. For example, David Tepper’s re-allocation of his fund into US banks in 2009 was a phenomenal calculated gamble. While the street believed that banks will be nationalized by the US government, he was the only voice to bet against it. Stock prices bottomed and quadrupled in less than a year. Tepper’s fund earned $7 billion from the trade and Tepper made a personal fortune of $4 billion. That is the power of timely re-allocation.

One thought on “How and when must you re-allocate

  1. The Indian market throws up a plethora of challenges.
    Firstly, markets are at a trailing valuation of 24.5 times.

    This is correct?……. Too high?


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