Part 2: How should beginners approach investing in the stock market?

by Manshu on March 26, 2012

in Investing for Beginners

In part 1 of this series, I wrote about how most people get hooked to the stock market and how they evolve through the various stages of a speculator / investor.

I closed that post summing up my preference for long term investing, and in this post I’m going to write about two things that I feel are particularly important. First is an implicit assumption that long term investors make and second is how you should view a share or a mutual fund.

I think it bears mentioning that there will be a third part of this series as well.

The Assumption

If you are a long term investor you should recognize that there is an implicit assumption in what you’re doing, and that implicit assumption is that over the long term the stock market will go up.

The stock market is a barometer of the economy, and if the GDP rises then the stock market indices will also rise with it. About a year ago, Mr. Mukesh Ambani said that Indian nominal GDP could cross $30 trillion by 2030, and if the economy were to roughly grow at 15% – 16% in the next 20 years – I think the target will be met. Now, remember this is the nominal GDP growth rate (which doesn’t take into account inflation) and not the real GDP growth rate and that’s why it sounds high, but in reality this is close to the nominal growth we see today.

So, if the economy were to grow to 15 times its size in the next 20 years, you can expect the stock market to grow along those lines as well. There won’t be a perfect correlation, but if the economy grows then the stock market should rise as well.

By and large most stock markets have shown this to be possible, but there are exceptions like Japan whose stock market is just 20% of what it was 30 years ago and then there are long periods of time when the Dow didn’t move anywhere at all.

In India’s context, I think the risk is more political than anything else. If the political class doesn’t screw up policies and business environment then this growth should be attainable. From recent experience, we know that they are capable of screwing it perfectly well.

It’s important to understand that long term investing does rest on this assumption because if you don’t understand this then you can be lulled into thinking that the market will always go up no matter what so it is safe to have all of your cash in the stock market. There is no guarantee that the market will always go up so it is best to have a portfolio that is diversified between shares and fixed income products.

The next thing that I think is important from the perspective of a long term investor is to understand the nature of a stock or share – to know what is it that you are buying or selling.

What is a share?

Long term investors and traders view a stock or share very differently. While traders are more concerned with the price and volume action of the stock, long term investors are concerned about the underlying business of the company.

They view the share as part ownership in the company and the correlation in their mind is between earnings and share price. If the company continues to grow profits many years down the line then the stock price will also rise to match that growth.

If you think of stocks like this you will start thinking of expensive or cheap stocks with relation to the money they make. So, when you look at a company you will think in terms of how much money the company makes (earnings or free cash flow) and how much it is selling for (market capitalization) and base your value decision on that.

A lot of investors will never buy individual stocks and there’s good reason for that but even then you need to be able to view stocks in this way to stomach the inevitable volatility that exists in the market. This outlooks helps stomach volatility because when the market falls by 20% or 30% in a short period of time you are able to look at the earnings of the companies whose shares have fallen and say to yourself, surely this company will not go bust and the stock price will not go to zero.

I believe this kind of outlook helps people deal with the volatility that has been part of the Indian markets for very long and will most likely continue to exist in the future as well.

Even if you buy mutual funds – it is the same thing since a mutual fund in turn holds shares and it is nothing but a representative of the value of the shares that the fund holds.

This of course is not true if you’ve been buying penny stocks or hot stocks which can go down very fast, and then never recover, but if you have been steadily buying decent stocks over a long period of time then this will hold true.

So, to sum it up, long term investors do rely on the somewhat obvious (even if unspoken) assumption that in the long run, the market will move upwards and you have to view a share as part ownership in the company to be able to truly appreciate what you are buying.

Next, Monday I’ll have the third part of this series and if you haven’t read the first part which deals with how people get hooked to the markets and how they evolve through different stages, then I recommend you read that as well.

{ 61 comments… read them below or add one }

Krishna March 26, 2012 at 7:42 AM

Dear Sir,
Excellent. My question may be a bit naive but how long is long-term?(Years or Decades).

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Manshu March 26, 2012 at 8:09 AM

I think at least a few years – say more than 3. I don’t know if you can have a holding period shorter than that and then think of it as long term.

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ANIL KUMAR KAPILA March 26, 2012 at 10:55 AM

Hi Manshu
I think there is a lot of confusion regarding the definition of long term. Moreover, the definition is different for different types of investors.For most investors investing directly in the stock market more than three years is definitely long term.
However, according to most mutual fund investors more than three years comes under medium term.According to different sources which I have come across, for mutual fund investors, more than 5,7 or 10 years has been specified as long term.

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Krishna March 26, 2012 at 7:24 PM

Thanks for quick reply.I am now more confused than ever;)
Sir,if you buy any stock how long do you hold it?just want to know from your experience.
lol

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Manshu March 27, 2012 at 3:33 AM

My experience has been 3 years or longer and it could have been longer but I’ve had to sell off twice because I needed the money. If I hadn’t need the money then I wouldn’t have sold.

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ANIL KUMAR KAPILA March 27, 2012 at 7:58 AM

Hi Manshu
Some financial planners suggest that we should invest only that money in equity which we do not need for atleast five years.

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Manshu March 27, 2012 at 8:10 AM

By and large I agree with that but then sometimes there are unforeseen expenses and you can’t do anything about it.

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ANIL KUMAR KAPILA March 27, 2012 at 8:40 AM

Hi Manshu
Do you maintain contingency fund? If yes, then how much should one have?

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Manshu April 2, 2012 at 4:39 AM

Yeah, I do – I think at least 3 months expense is good, but in my case it’s more than that. Since my wife also earns, here I’m talking about joint finances.

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Manshu April 2, 2012 at 4:39 AM

In the context of this question – when I said big expenses, I should have really said big investments.

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Chandran May 18, 2012 at 4:01 AM

Hi Manshu,
I have a question about the tax implications for a long term investor who is not aversed to a few short term movements also. For example the situation you mentioned above – like having a personal need and the stock is overvalued at that time.
Against this background, if I as a long term investor buy a stock for, say Rs.1000/- and within a month the stock price drops to Rs.700/- I still wish to have the stock from a long term perspective. My question is, is it advantageous to sell and buy again and realize the short term capital loss, so that if I make a gain some time the loss can be utilized?
I understand the expense of brokerage and the potential price movement up before I buy. With the huge price drop, such movement in a day or two is very unlikely. Apart from this, is there any other problem? What is your view on this?

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Ramesh March 26, 2012 at 8:40 AM

I think for simplicity the terms should be universalized say

Ultra short term – less than 1 yr
Short term – 1 to 3 yrs
Medium term – 3 to 5 years
Long term – more than 5 yrs

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Manshu March 26, 2012 at 8:44 AM

There is no easy way to standardize since everyone has their own definitions and the way they work is different too especially in different countries. I think in India, where people are talking about selling next week or next month, finding someone who is willing to hold on for even a year or two is quite rare 🙂

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ANIL KUMAR KAPILA March 26, 2012 at 11:34 AM

Hi Manshu
I would like to quote Robert Cole the editor of the Tempus Investment Column.
Stock market history suggests that the reliable returns are generated by long term investors-those who invest for five years or more.
Remember also that the long term is made up from a series of short terms joined together. Get short term decisions right and the long term performance will be enhanced.

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Ams March 26, 2012 at 11:57 AM

SIP is the safest bet as it can deal with the volatility. When so many MF SIP’s are available why should an individual who has a long term perspective even think about investing in the market directly ? Secondly ther fund manager would be taking care of the part of continously watching the market which an individual who is doing a job will not be able to do.

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ANIL KUMAR KAPILA March 26, 2012 at 3:31 PM

Hi Ams
I think for beginners investing in diversified equity mutual funds via SIP route is the best option.

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Arvind March 26, 2012 at 2:12 PM

excellent write-up.

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Manshu March 26, 2012 at 6:23 PM

Thanks!

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Paresh March 26, 2012 at 3:15 PM

Traders who are in profit are always short term investors..
Traders in loss are always long term investors…they can wait for decades to come in profit.
if some one stay so much long term then understand that he is in loss.

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ANIL KUMAR KAPILA March 26, 2012 at 3:35 PM

Hi Paresh
I think investors and traders are different set of people. Investor can never be a trader and a trader can never be an investor. Investment horizon is what separates them.

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Paresh March 26, 2012 at 4:32 PM

Hi AnilJi,
Just I was talking about real time scenario…
If suppose today I buy a stock and if within 3-4 days it zoomed by 8-10% then I will tend to book the profits and if it is in loss then I will wait for months,years, decades..

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Manshu March 26, 2012 at 6:25 PM

My finance prof used to say that a long term investor is a trader who is sitting on a loss 🙂

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Paresh March 26, 2012 at 6:37 PM

Yes…true…no other reason for him to stand positionally.

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ANIL KUMAR KAPILA March 26, 2012 at 7:52 PM

Hi Paresh
According to behavioural economics, the pain people feel from losing money is far greater than the pleasure they get from winning money. This leads them to cling on to losing investments in the hope that they will return to profit.
I have recently read – Investing rules from the masters.
I find that investing rules of one master are contradicted by another master. According to one master- You should not be emotionally attached to your investments.
Another master says- Buy right and hold tight. Time is your friend, impulse your enemy.

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Paresh March 27, 2012 at 8:57 AM

Dear Anilji,
As far as psycology is concerned Just I remember one slogan read on one of the T-shirt today:”I want to change the source code but what can I do ..I don’t have access of it.” Common experience is that I understand but I do not learn anything from my old mistakes,others experiences or mistakes done by the greedy couple who cut the golden egged hen or greedy king of midas..

as far I think,success in equity investment dependant of couple of things only:
1.Entry point:It doesn’t mean that entry should have done at the bottom only,,but at least somewhere at the cheaper level.
2.Trade Plan:For any trade plan,entry and exit (whether in profit or loss) should be defined and executed for each trade…after profit – loss summation,trader will be in profit only for good trading plan.
3.Equity investment should be independant of time horizon but it should be more related with the targets.

Regarding mutual funds also,,success of SIP highly depends on how market revolves in future..

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ANIL KUMAR KAPILA March 27, 2012 at 9:20 PM

Hi Paresh
Theoretically I agree that entry point is important. But then it is impossible for anybody to time the market. Even finding a cheaper level is not easy. Just five minutes back I was watching news on a business channel. I heard atleast three market gurus saying that from today’s level the market will only go up. I don’t know on what basis they are saying that.
I have no dispute with the trade plan.
I do not agree that equity investment should be independent of time horizon. Ofcourse all investments must have some target. But target can not be set independent of the time frame.
Yes, I agree that return of mutual funds is linked with the performance of the market whether done via SIP or lump sum.

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bemoneyaware March 27, 2012 at 11:55 AM

What an insightful post and discussion. My two cents are:
One should have a plan in mind before one invests whether it is a mutual fund or a stock. One should understand why one is investing, what are pros and cons of that investment and when should one redeem.
Ex: If I need assured returns after 15 years I can invest in PPF,
if I need after 1 year I can invest in FMP rather than FD to be tax efficent.
If I need growth to beat inflation then I can invest in Equity Mutual funds through SIP or stock markets for whatever I define as long term (3 years, 5 or 10) or associated with my goal.
As they say Failing to plan is Planning to fail

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ANIL KUMAR KAPILA March 27, 2012 at 9:03 PM

Hi Kirti
I broadly agree with you. I have to add only this that risk appetite as well as capacity to take risk is an important consideration. If I have neither any risk appetite nor any capacity to take risk then I will prefer to go for a bank fixed deposit than FMP even if I have to pay higher income tax.

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justgrowmymoney March 30, 2012 at 2:59 PM

Manshu – GDP growth and Stock market returns are not at all corelated bsed on historical statistics.

In India the stock market consists of 7000 companies (50 in the Nifty as we know) while the GDP growth is contributed by millions of companies. Ford cars produced in India add to India’s GDP. Accenture and CapGemini deriving software services revenues in India will add to India’s GDP. Agricultural produce add to India’s GDP. Textiles, Shoes, Furniture, Machinery all made in India by un-listed/foreign companies also add up India’s GDP.

It is just a general expectation that the index components in the stock exchange also will grow with the companies in the rest of the country – But it is not true!

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Manshu March 30, 2012 at 6:26 PM

Do you have a link to the data that shows they are not correlated? Preferably over a long period of time and across multiple countries.

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Manshu March 30, 2012 at 7:15 PM

For reference, here is a short post on the correlation on S&P & SPY over the long haul

http://seekingalpha.com/article/270159-the-historical-relationship-between-the-economy-and-the-s-p-500-part-1

If you find that a country’s GDP has grown but not the stock market then I’ll be really curious to look at it.

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justgrowmymoney April 2, 2012 at 12:16 AM

Manshu – Please check out http://justgrowmymoney.com/Downloads/GDP_vs_DJIA.xls

This is part of a research paper I started working in 2010 but did not pursue further so what you see may be work-in-progress draft document.

The visual representation shows that the GDP and Dow Jones have a very low correlation. When the economy contracts in a recession the stock market may fall much more. But until the GDP improves over a period of time the markets do not bounce back. There is an inbuilt lag between their returns (not that they are correlated).

Again the GDP is arrived at contribution by non-stock market listed firms as well which explains why the GDP and the Index are not necessarily related.

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Manshu April 2, 2012 at 3:35 AM

Hey I looked at the file and you’re talking about GDP growth in a particular year with the stock market movement in that year!!! This is not even remotely close to what I’m talking about here!!!

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justgrowmymoney April 2, 2012 at 11:45 AM

This is precisely the data that shows Stock Index and GDP have a very low correlation. There are numerous studies that have shown this.

While it is a general expectation that the Index companies will grow with the rest of the economy (GDP) it is not necessarly true.

Indeed the Index companies may still grow positively with the economy as well but theie P/E may be lowered or have gone way higher which means the Index itself does not grow/grows big time not correlated to the GDP. That is what I am trying to tell.

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Manshu April 2, 2012 at 7:23 PM

We are both looking at this from different angles. Let me ask you this – is there a country – USA, Japan, China, Thailand, Mongolia, Brazil, UK, Germany, France, Italy or any other country which has grown for say 30 or 40 years but the stock market refused to grow? That’s what I’m talking about – not the correlation between yearly changes.

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justgrowmymoney April 2, 2012 at 8:44 PM

I now understand the angle you are looking at, my bad!

I have 2 examples not satisfying all the criteria you asked but some:

1) Japan is the classic example:
Japanese Index hit a high of 38000 in Dec 1989 and has never crossed that level since then for 23 years. The Nikkei is trading at 10,000 levels as on March 2012, a 75% drop. GDP has been growing at a nominal rate of 2-3% since 1989. There were 2 times the GDP growth was negative – 1997 Asian currency crisis and 2008 recession but for which the GDP has always been positive.

2) US:
The Nasdaq and S&P have not hit their 2000 levels yet and were reeling way below even 6 months back (now getting relatively closer) while for all these 12 years the US economy shrinked only in 2009 growing at a healthy 4% for its 14 trilion size.

From the great depression of 1929 it took 20 years for the markets to break even but the GDP growth was EXTREMELY high especially during the WWII from 1939-1945.

I have personal experience in these markets to know their numbers. If we sit and dig out it will be clear almost all markets will exhibit such phenomenon.

Over 30-40 years yes the GDP and Stock Index will be both positive likely (leave the Japan exception) – however since a majority of the investors dont have the temperament to hold on to that long (considering people cant even hold for 1-2 years) expecting market gains alongside GDP growth is not necessarily right because GDP growth is contributed by non-index companies primarily.

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justgrowmymoney April 2, 2012 at 8:55 PM

I think I did not make something clear!

Long term investing is the (mostly) guaranteed form to build wealth than almost ALL avenues and I am completely sold on that. Staying invested longer will yield the best returns for one. But it may not be correlated with thr GDP is what I was trying to imply.

If someone wants to time GDP growth and make investments it is wrong. If a SIP is continued rain or sun shine then immense wealth can be generated

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ANIL KUMAR KAPILA April 3, 2012 at 7:02 AM

I do not know about historical statistics but certain parameters of economy affect GDP growth as well as stock market returns. For example high inflation which results in high interest rates definitely impacts market returns as well as GDP growth.

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ANIL KUMAR KAPILA April 3, 2012 at 6:34 AM

Hi Manshu
I find a lot of comments are there in the mail but those are not appearing here.

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bemoneyaware April 3, 2012 at 10:04 AM

Great observation.
My guess is because of wood-sculpture moved from a shared web host to a VPS (Virtual Private Server). In layman terms it means all files,data etc was moved from one machine to another.
Suppose the data was copied on 28th Mar and new webhost became operational on 30th Mar. Though wood-sculpture was active between 28th Mar and 30 Mar on the old machine, the data between 28th Mar and 30th was not copied. As it was on old machine when the new machine became active that data got lost.

Manshu there are some extra characters in some of your old posts Ex:
we’re in Capital Gains and Dividend Taxes on Shares and Mutual Funds
This is another post from the Suggest a Topic page, and this time we’re going to take a look at how capital gains – short term and long term as well as dividend distribution taxes are charged on shares, equity mutual funds, debt mutual funds, and Gold ETFs.

Not sure but you might need to change the UTF setting in wordpress wp-config.php.

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bemoneyaware April 3, 2012 at 10:07 AM

Great observation.
My guess is because of wood-sculpture moved from a shared web host to a VPS (Virtual Private Server). In layman terms it means all files,data etc was moved from one machine to another.
Suppose the data was copied on 28th Mar and new webhost became operational on 30th Mar. Though wood-sculpture was active between 28th Mar and 30 Mar on the old machine, the data between 28th Mar and 30th was not copied. As it was on old machine when the new machine became active that data got lost.

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bemoneyaware April 3, 2012 at 10:08 AM

reat observation.
My guess is because of wood-sculpture moved from a shared web host to a VPS (Virtual Private Server). In layman terms it means all files,data etc was moved from one machine to another.
Suppose the data was copied on 28th Mar and new webhost became operational on 30th Mar. Though wood-sculpture was active between 28th Mar and 30 Mar on the old machine, the data between 28th Mar and 30th was not copied. As it was on old machine when the new machine became active that data got lost.

Manshu there are some extra characters in some of your old posts Ex:
we’re in Capital Gains and Dividend Taxes on Shares and Mutual Funds
This is another post from the Suggest a Topic page, and this time we’re going to take a look at how capital gains – short term and long term as well as dividend distribution taxes are charged on shares, equity mutual funds, debt mutual funds, and Gold ETFs.

Not sure but you might need to change the UTF setting in wordpress wp-config.php.

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Anil Kumar Kapila April 3, 2012 at 6:27 PM

Hi Manshu
I changed my browser to Mozilla Firefox. The problem seems to have been resolved. Thanks for your observation.

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Manshu April 4, 2012 at 4:24 PM

Thanks for your email Anil, the setting was changed in the config file which was possibly causing this issue so I think we should see things back to normal in a couple of days but if you do see problems then please do email me and I’ll research this some more.

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Anil Kumar Kapila April 5, 2012 at 6:25 AM

Hi Manshu
With Mozilla Firefox there is no problem but with Google Chrome the problem still persists. So for wood-sculpture I use Mozilla Firefox and for all others Google Chrome.

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Manshu April 5, 2012 at 7:02 PM

Hi Anil,

Thank you for letting me know. I’m going to look at this some more and hopefully there will be a simple solution. Thanks!

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harinee April 4, 2012 at 10:41 AM

My greatest fear on long term investement is what I wait and find India goes the Japanase way. Thats like a complete wipeout.How did the Japanese inevestors handle such a fall?

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Manshu April 4, 2012 at 4:13 PM

But the rise before that was pretty high as well, and the fall is because the rise was so steep on the back of a real estate bubble.

Now, here I’m not saying that it could never happen in India, I think it could and certainly our government is trying very hard to make it happen.

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Anil Kumar Kapila April 5, 2012 at 6:35 AM

Hi Manshu
I am an optimist. Although the politicians do their best to throw spanners in running machinery, we Indians know how to get around all the obstacles.

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Manshu April 5, 2012 at 7:01 PM

Well, Amen to that.

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justgrowmymoney April 5, 2012 at 2:21 PM

Harinee – Japan is one hell of an exception!

An anti-dote to this would be to do an Asset re balancing every time one’s asset allocation goes some 10% points beyond your target. Doing such allocation would have helped protect significant profits during the uptrend. In case of India when sensex rose from 15k to 21k in 2007-2008 in 6 months if someone had rebalanced portfolios every month they would have booked profits on the way up and bought more and more on the way down and would have ridden to profits yet again when the sensex moved from 7000 to 21000 again in 2 years (Mar 2009 – Nov 2010).

As easy as it is to say this in hind sight I agree it is practically difficult to implement as we only look into increasing profits in an up market and never think about booking profits. Having only Debt is a guaranteed way to lose on the Inflation war. Having MF/Stocks is a way most likely to meet all goals – but if a Japan scenario happens one is indeed doomed.

The odds are all stacked up against an investor in both Debt and Euity investment. Euity at least offers VERY bright chance of winning the race! Lets all run keeping an asset allocation in mind!!

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Anil Kumar Kapila April 6, 2012 at 7:23 AM

I agree that asset allocation and rebalancing are important but rebalancing every month is not practical. Even if it is done every year or once in two years or when allocation is significantly off target it should be fine.

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justgrowmymoney April 6, 2012 at 9:33 PM

I agree. While indeed 12-18 months may be a good time to rebalance, the market peak is always accompanied by a large run in a very short time (15k to 21k in 6 months in 2007-08) and the asset allocation would have gone out of target by 15+% some 2 or 3 times even when rebalanced each month/two in that period of run up.

Easier said, than done!

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justgrowmymoney April 6, 2012 at 9:55 PM

Easier said than done, to rebalance, I meant!

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Anil Kumar Kapila April 7, 2012 at 7:01 AM

We are not likely to see any market peak in near future. Hence rebalancing will not be required for quite some time. I have not done any rebalancing for the last two years. I have been investing mostly in balanced funds which have some amount of built in rebalancing.

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justgrowmymoney April 7, 2012 at 1:22 PM

I am referrfing specifically to the peak in 2007-8 when market ran up some 40% in 6 months. In such times rebalancing alone will help protect profits to a good extent, is what I intended to say.

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Anil Kumar Kapila April 7, 2012 at 6:43 PM

What I am saying is that we are unlikely to see the peak similar to 2007-8 in near future. If we approach 20,000 level I am sure most investors would like to book profits. But we have to wait for a long time for that to happen.

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justgrowmymoney April 10, 2012 at 8:21 PM

We wont know that really. It is a very educated guess but perhaps just that.

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chand April 9, 2012 at 4:20 AM

Thanks Manshu for these articles! Not only it would help the beginners immensely but also spawn good discussions in the comment section.

In my opinion one’s financial planning should be driven by goals. And it’s quite a finite list for an average Joe. e.g. marriage, home, car, big vacation, kids’ education, retirement, emergency etc. Each requires separate research and planning. Note that I have specifically avoided any mention of ‘short’ or ‘long’ term or even ‘investment’ in my statement. Some planning would involve ‘investment’ and others would be reasonable expenditure to meet ’emergencies’.

To give an example, I keep 6 months expenses in one or two money market instruments. Sometimes I put them in FDs too if the interest rate is decent enough. I put money into NPS, PPF and MF for my retirement which has a target date (and it assumes a particular inflation and return rate). I put money into FMPs for a long vacation planned one or two years from now. I buy personal insurance products to meet certain medical emergencies (which is of course not an investment).

If the needs are more immediate go primarily for debt otherwise go primarily for equity. Also, it does not harm to follow the thumb rule of age = debt percentage which I think you can cover when you talk about asset allocation.

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Manshu April 9, 2012 at 4:26 PM

Thanks for the great comment and insight Chand – I think what you’re saying makes sense. Asset allocation – I wonder if I haven’t written about this already, I have mixed feelings when it comes to age and asset allocation. While I agree that for older folks you shouldn’t have too much exposure to equity, I think the same applies to younger folks who don’t want to be bothered with volatility. Will probably be an interesting topic for discussion.

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