Booming market? Strategies for investing

When the Sensex crossed 15,000 points last week, there was a clear euphoria among the players.

Add to that a growth rate of 9.4 per cent in the economy, inflation under control and good monsoon expectations and we have a heady mix for the stock market investor.

But there is confusion as well. Each new high is also followed by a fear that whether the market will stay strong in the future? Or is a correction likely to happen?

For the lay investor there is a reminder of the mayhem in May 2006, when the markets  crashed. But then, there is also the element of greed that goads you to stay invested.

So what should you be doing? There are a number of strategies that one can follow. Here are a few:

Holding a constant proportion in stocks

This strategy is called the 'Constant Mix Strategy' in financial terminology.

To implement this strategy, you need to hold a constant fraction of your investments in stocks. When the stock market falls, you buy more stocks to keep the proportion of stocks in your portfolio constant.

Similarly, when the market rises, you sell stocks to maintain your portfolio balance. The main advantage of this strategy is that your asset allocation remains at a planned level, therefore keeping your risk under control at all times.

For example, you have decided that your portfolio should be 50 per cent  in equities and balance in other investments (eg fixed income, real estate etc) at all times. Let's see what happened from July 2006 to July 2007.

In this time period, the proportion has shifted from 50:50 to 57:43. To bring it back to the original level, you will need to sell about Rs 1 lakh (Rs 100,000) of stocks and invest in other assets.

By doing this, you would have automatically taken advantage of the high stock market without completely exiting from it. Moreover, this Rs 1 lakh has been now diverted to other markets that have not performed as well and therefore, may perform better in near future.

Looking at the current market conditions, this strategy could work well since the fixed income instruments (like FDs, etc) are offering good interest rates.

The critical aspect of this strategy is to determine what should be your "constant mix"? Should it be 40 per cent in stocks or 60 per cent? This proportion depends on many factors like your investment objectives, time horizon of investment, liquidity requirements, risk profile and also other investment opportunities available in the market.

However, a point to note here is that one  needs to pay attention to the taxation as well as transaction costs while using this strategy. If you sell shares in less than a year, you will be liable to pay 10 per cent short term capital gains tax. All things equal, in case of profits, it may therefore be ideal to sell stock that you have been holding for more than one year. Similarly, too frequent buying and selling will result in high brokerage costs. This inflicts similar damage to your portfolio as taxes.

Keeping these factors in mind, you will have to decide, at what interval you would want to balance your portfolio to the original level -- monthly, quarterly or yearly etc. This strategy is suitable for moderate risk takers.

Buy and Hold

This is an age old strategy and needs no explanation. You simply buy stocks of companies you believe in and hold them for years together. For those who are not into it full time, could achieve the same result by investing through mutual funds.

The best known proponent of this strategy has been Warren Buffett. His billions are a result of this simple strategy. In India as well, those who have held on the stocks like Reliance Industries, Dr Reddy's, Cipla, Infosys and Wipro since the early 1990s have a similar story to tell. They can practically retire on these investments.

The other advantages of this strategy are very low transaction cost and no capital gains tax. Since you wouldn't be buying or selling frequently, you pay very little to your broker. Moreover, your sale will attract no capital gain tax as your holding period would be more than a year.

Even with so many advantages, few actually practice this strategy. It requires conviction in your investments and loads of patience. This strategy is most suited for those who are look to stay invested for the long term.

Capital guaranteed

This is best suited for very conservative investors.  who does not want to lose any money and at the same time doesn't want to be completely out of the market.

How does this work? Say you have Rs 100 and you wish to invest for a period of three years. The markets are at 15,000 levels and you are not sure whether it will scale new highs. 

In this method your priorities are:

1. Protection of Rs 100 in three years (ignoring inflation)

2. Do not want to miss the rally

Since capital protection is your primary goal and equity participation secondary, your strategy would be to invest a portion of your assets in fixed income and the balance in the stock market.

The proportion in fixed income (FD) would depend on the interest rate in the market. An example: If the three-year FD is yielding 9 per cent (assuming no tax), you would need to invest Rs 77.21 in FD. You could invest the balance in stock market without losing any sleep.

Even if the markets fall drastically and your equity investments practically vaporise, your FD portion would have grown back to Rs 100 in three years. If your investment horizon was longer, say five years, then you would need to invest only Rs 65 in FDs to achieve the same result.

As your time horizon increases, you could invest more in equities and vice versa. Moreover, the longer your time horizon, the more time you would give the stock market to recover as well!

These are the three simplest strategies you could follow without living in a dilemma of what to do. It is important to remember that when markets are doing really well, it also means that more and more stocks could be over priced.

Fundamentals in these cases will take time to catch up. Till that time, fasten your seat belts, pick a strategy for your portfolio and enjoy your investments.

The writer is director Acorn Investments Advisory Services.