The year so far has been tough for equity investors. Recent events have made things worse. Ok, context time (though we doubt you really need it!).
The equity markets are cracking and stock prices are moving lower with renewed force as the crisis in Ukraine worsens. The Sensex as of 7th March 2022 was trading at sub-54,000 levels. Global commodity prices are rising dramatically with Crude oil at a high point of $139.
Equity investors with significant exposure are wondering what to do as they see their portfolio values drop. It’s tempting, especially now, to want to take out bulk of your portfolio allocation where the value is only declining. Many of you may be wondering if you should re-allocate it to assets like bonds and fixed income, where you are at least more at peace about preserving your initial capital.
However, shifting allocation across assets has a cost implication.
It’s not just the tax and fees you pay, but also the opportunity cost of moving long term, wealth creation linked allocations into stable income assets where returns are lower.
To address any jitters you may have, here are some practical solutions you can implement.
The TL;DR version is to know your needs and allocate to fixed income the money you see yourself using in the next 3-4 years max. Focus on long term post-tax growth of your overall wealth over a decade long period at least. Unless the world and the global economy cease to exist, equity markets will eventually pick back up if not now, then in a few years.
So here is the detailed 4-minute reading time answer to the question raised in the headline.
First of all, ascertain any near term needs
Is there money you are likely to redeem from your equity portfolio for a goal that is less than two years to completion?
If there is such a goal, then the amount for that is what you need to keep aside in stable return assets like bonds. The rest of your equity allocation can be left as is. Equity is a long term asset and volatility in prices is part of the journey and to be honest, inescapable.
When you are making this switch, choose the bonds with care. It’s a myth that you have no risk in a bond investment. While price volatility might be missing, there is a default risk to contend with.
Good quality corporate bonds, risk-free Government securities, or short term money market funds are all potential choices for allocating money where capital preservation is of paramount importance.
Also, try to allocate such that the maturity of the underlying bonds matches the time horizon of your monetary needs for the goal in question.
Second, always consider long term, post tax
Long term and post-tax, are key considerations for investment gains. Long-term is not 2-3 years, think a decade or more.
Where you need the money, sure, you can look at a lower time period, but for everything else, just letting your investment returns compound over time is important.
Assuming you have bought good quality stocks or equity funds, recognize that returns take time to compound, just like business profits take time to grow.
Secondly, every time you sell at a profit and take money out, there is a tax implication.
Debt capital gains taxation in the short term is significantly higher than equity short term capital gains tax, for those in the higher income tax bracket. Tax is a real outgo beyond your control and it does eat into the gains you make.
Third, don’t forget the real return
Real returns refer to the impact of inflation on your gains. Inflation is the invisible tax you pay when the economy is growing. Literally speaking, inflation is the rise of prices in goods and services, which in turn, reduces the purchasing power of your money.
In order to make your investment returns efficient, you need to earn more than the long term inflation. Returns measured net of the inflation impact are known as real returns and positive real returns are best addressed with long term equity allocation.
What you should takeaway
All these three aspects, if left unconsidered, can eat into your net wealth growth. Hence, don’t be in a hurry to switch out of equity, especially due to price volatility. Marry this switch to your goals.
When you think of your portfolio in these terms, you will realise that allocation and switches in allocation are less about what is happening in the market today and more about what you want from your money in the long run. Keep your short term money requirements in bonds and other fixed-income assets, leave your long term money in equity despite the volatility.
Equity market levels on a daily or even monthly basis, are hard to predict. However over time, in a growing economy like ours, equity market returns are expected to match the rate of nominal growth. Try your best to be patient and switch only if you need the money in the next 2-3 years.