Why investors should rethink heavy equity exposure

The past few years of equity outperformance has made investors consider this asset category as TINA (There Is No Alternative). This has made consistent higher inflows ignoring other asset classes. The phenomenon is not quite restricted to India but also in much of the rest of the world including the US. A recent data shows that investors in the US own more in stocks than they had in a decade. (78 per cent vs 75 per cent in 2015) and conversely their exposure to debt is 22 per cent vs 25 per cent. A morning star article further went on to check the assets amounts during these periods and concluded that about $800 bn in excess investment towards equities currently.

Why this is a scary scenario is that while the equity markets have scaled newer highs in most parts of the world (barring China), the valuations have also reached to stratosphere levels. Usually, equity markets price-in the forward possibilities of the business/stock and thus the stock prices move accordingly. To just sustain the valuations of the rallied stocks, the earnings must consistently hit the current trajectory for multiple years, continuously.

I’m not betting against that these businesses (those with higher valuations) can’t continue to deliver in the immediate term but the world is very dynamic and is prone to disruptions through war, geopolitical tensions, regulatory modifications, calamity and/or technological changes. So, to extrapolate the current earnings, margin expansion and market shares to long future is always perilous. Moreover, history shows that each time such higher valuations have led to lower future returns.

No, I’m not suggesting the equity markets crash or correct immediately but corrections are a feature than a bug in the market. Most people also tend to misinterpret risk. When they mention risk in equities, they equate to the volatility and possible loss (even at times permanent) to their portfolios. However, what they don’t understand is that risk not actually means what the asset does but how it could impact the investor.

Understanding risk doesn’t mean how the asset behaves but how it would affect the investor behavior. This is the reason at the first place, why diversification and asset allocation are considered. This is in tune with their risk tolerance and financial goals. In a bull market, the market’s unidirectional movement could soften or lull their instincts towards risk. This could lead to investors taking higher risk than they should ideally stick to and hampers their rational judgements.

If the investor has begun them investment journey without such considerations, they should immediately pay attention to this and allocate accordingly. In cases where the investors have done the asset allocation based on their risk profile then they should review by rebalancing their portfolios. The easiest way to gauge whether an investor requires to go for rebalancing is to re-look at their initial hypothesis.

One needs to compare why and how the allocation was done, compare it with their mix and how it has changed. Now, they need to look if their goals, risk parameters and circumstances have changed since then. This allows the investors to have a rational approach at assessing the assumed risk in their portfolios vis-à-vis the actual. They could resort to rebalancing their portfolio if there are deviations to the allocation than deemed.

Moreover, the recency bias makes the investors to allocate further on an outperforming asset or avenue piling up their proportion in the portfolio. This could turn dangerous when the momentum turns otherwise. Like in a balanced diet, investors should allocate a minimum towards most of the assets while actively tweaking the portfolio over the fringes of their ideal portfolio for generating higher alpha. Thus, asset allocation and diversification are important, rebalancing of the portfolio is crucial time-to-time.

(The author is a co-founder of “Wealocity”, a wealth management firm and could be reached at [email protected])