We frequently get the following questions from new investors:
Is the market too high to enter?
Should I wait for markets to fall a bit?
The reality is one doesn’t really know in which direction the broad market is going to go next. It is never necessary that markets have to fall just because they’ve risen a lot in the recent past. Hence, timing the broad market is kind of foolhardy (though we do time entries/exits into individual stocks/sectors all the time!).
However, it is quite probable that someone enters at the peak of a bull market and sees an immediate 10-15% drawdown from their cost. While older investors are a happy lot because they are still in the green (just that profits have reduced a bit from the top), the new investor is pained at seeing red in their portfolio.
We have tried to eliminate this very market timing risk for new investors.
How we do it?
Let’s say we originally bought Company A at Rs. 100 in our portfolios with a 5% allocation.
A new investor comes in when the stock is trading at 125. The risk for the investor is obviously more than the person who got in at 100.
Now, normally in any mutual fund investment or in any AIF, and in some PMS schemes, we would get all stocks in the same allocation, irrespective of their time of entry. What’s more – if a stock doubles, the allocation of it within the portfolio also doubles, and you end up buying double the allocation than what it was bought for originally! This reduces your margin of safety by a large margin.
We dynamically adjust the allocation of stocks which have run up from our original entry price. So, if you buy Company A at 125 (which was originally bought at 100 in our portfolios), you would buy it in a lesser allocation than what it was bought for originally. This ensures the risk of investment in that particular stock stays constant for all investors (old and new alike).
What’s more – If you replicate this allocation adjustment exercise across all stocks in the portfolio, the total portfolio risk of each investor stays constant, irrespective of whether you entered the stock market at highs or lows. The drawdowns (if any) from the highest point would be same for all accounts, new or old and also of the model portfolio. Sometimes, we also end up keeping a lot more cash/liquid funds in newer accounts than in model portfolios because of lesser allocations to individual stocks. So, it ends up being asset class allocation adjusting mechanism as well, depending on where you are in the equity market cycle.
The SIP case
This is also useful even if you are an existing investor and want to add new capital. Whenever you are adding new capital, it is obviously better not to add all stocks in the same proportion as in present portfolio because some stocks would’ve run up, increasing their allocation in the portfolio. This is exactly what happens in a SIP in a mutual fund. You end up allocating more to the stocks which have run up more.
Rather, it is better to adjust allocations in the above manner so that the risk% in any stock stays constant. For new additional capital, in proportion, we end up buying less of the stocks that have run up versus the stocks which are near our original buy prices. Only if the stock is still good as a fresh buy, we increase the allocation to the original buy quantity.
All of this keeps your risk/maximum drawdown similar to that of model portfolio (from a particular date), irrespective of whether any rupee of your capital enters at the top of a bull cycle or at the bottom of a bear cycle!
Please reach out at firstname.lastname@example.org or comment below if you have any views or questions!