You Shall Not Pass: Determination and Boredom in ‘Range-bound’ markets

“You Shall Not Pass.” This was famously used in J.R.R. Tolkien’s The Fellowship of the Ring, the first volume of The Lord of the Rings. In the novel as well as in the movie based on it, the wizard Gandalf declares staunchly, “You shall not pass!” while blocking the Balrog (a demonic creature). A bit of googling reveals that the phrase was originally used during World War I, during the Battle of Verdun, by a French General, Robert Nivelle. It has since been used as a slogan or a war-cry to express determination to defend a position against an enemy.

You-shall-not-passIt was this kind of determination that was required today in the Lords Cricket Test that India lost to England. Nobody quite strongly said “You Shall Not Pass” to the English bowlers, and it was a matter of time before it was wrapped up.

For the past few months, the market too seemed to be tied in a deadlock with the bulls and the bears saying ‘you shall not pass’ to each other, and not allowing either to get the upper hand. It has been a time when most business channel anchors use the term “range-bound” so often. It is so uninteresting to them to wake up every day in the morning, cover the hectic activity minute to minute, and finally it all ends up being ‘range-bound’ activity with ‘stock-specific’ action. There have been event after event created – from seemingly important ones like release of inflation numbers, quarterly results, IIP numbers, credit policy, Greek crisis, oil prices, European debt crisis, Chinese slowdown to tactical issues like expiry of the monthly series and daily volume turnovers. But the net result for the market has essentially been status quo. The end of every event makes everyone look forward to the next one – but the market again says – You shall not pass – I stay where I am – ‘range-bound’.

For an individual investor, perhaps neglecting all the action (or net inaction if you may say so) continues to be the best strategy. Lethargy bordering on sloth remains the best policy. The formula remains the same – fix your long term asset allocation, select and regularly keep adding to those assets, and rebalance once in a while when there are major moves. To everything else that tries to distract you from this path – the response should be – You shall not pass.

Why Having Fixed Income is Important for Portfolio Goals

The best portfolio strategy for an individual investor is to start by setting a prudent desired asset allocation between risky equity assets and fixed income that the investor is comfortable with and is sustainable, and implementing it by a continuous timely re-balancing of the portfolio. This would mean selling a certain percentage of the equity part when equities have done well, and buying the equivalent fixed income part, thereby resetting the asset allocation to the desired level, and vice versa.

fixedbondsstocksOne of the requirements of implementing this strategy is to have substantial holding of the portfolio (50% to start with) in fixed income or debt funds. Unless one has that holding, it is not possible for the investor to take advantage of low market levels with timely re-balancing. One of the chief advantages of this strategy is not purely mathematical or higher returns, but psychological – related to the mental stability that the average individual investor will experience in the face of falling markets. And if he is in that state, it is likely that he will not only continue investing, but if he has the temperament and discipline, he will also shift fixed income instruments to equity at a time when market levels are low – thus enhancing long-term portfolio returns. This strategy of holding fixed income to some extent when equities are going through the roof also will give him the ammunition to do the right kind of re-balancing when equities tank, and will ensure that like other investors hurt in the crash, he will not run away from the market.

But that also means that when equities are running high, the investor has to be content (and can get a bit impatient) with lower returns due to the debt component. This will take considerable will power and temperamental maturity to stick to, even for the most disciplined individual investors – at least in the initial years of their experience.

So does fixed income play a role or is it only for fuddy-duddy’s to hold? That is a question best answered by the investor himself. But in my experience it does play a role – though that role diminishes as the equity portion of the portfolio increases specially after the investor has seen a couple of economic cycles. So the best path may be to start with an ideal, conservative allocation of 50:50 in the initial few years of investing. The investor will inevitably face the mentally tough situations of large market falls, and get tested. In such situations, the investor is likely to experience and observe his own behavior – whether he falls prey to market vagaries by selling his equity holdings, and stopping further equity investments; or whether he focuses on his asset allocation and shifts some of his debt holdings to equity to re-balance, thus taking advantage of lower market levels. Similarly, he is also likely to go through easier, seemingly feel-rich market situations when equities go through the roof, and see for himself whether he has the mental orientation to sell equities and shift to debt, or ends up going with the crowd increasing his equity exposure.

After having gone through a few such situations in the initial few years, the role that debt funds play in an individual investor’s portfolio is likely to be self-evident. In case he is actually investing regularly with increasing income levels with time, and has gone through a couple of market cycles, it may then be prudent for such an investor to progressively reduce the percentage allocation to debt. Simply because he is confident that he can handle market volatility easily, and secondly because, his portfolio is likely to have reached a size where the effects of re-balancing will likely give diminishing returns.

So yes – debt funds or other fixed income instruments do play a definite role throughout an individual investor’s lifetime. It plays a larger role in the initial years when the effect of asset allocation and re-balancing need to be proven and seen by the investor himself. Unless an investor has fixed income investments, it is not possible to take advantage of market falls by making tactical shifts to equity – thus losing out on long-term portfolio returns. Beyond the first few years, fixed income will still play a similar role where it acts as an income earning store of booked past profits, as well as a pool to access when lower market levels warrant a shift to equity. But the investor can potentially afford to be a bit more confident of his ability to handle market volatility at that stage, and progressively reduce the allocation to fixed income to enhance returns – while still maintaining the percentage of fixed income assets to a significant level. It may be prudent to start with 50:50 allocation initially, and over years and experience of making regular investments, and implementing the asset allocation and re-balancing strategy, progressively reduce the fixed income allocation – but perhaps, never dropping it below 25%. As market vagaries will still continue, and he will still need a store to take advantage of it – and in larger quantities to make an impact as his portfolio size increases.

Gold and its Glitter: Role of Gold in Portfolio Asset Allocation

“You can fondle it, you can polish it, you can stare at it. But it isn’t going to do anything.”

That’s what Warren Buffett had to say about gold. Essentially it is a useless commodity. But it has gone up every year for the last 10 years. It has given returns that are, perhaps, better than almost all asset classes over the last decade, including stocks and real estate.

goldimagesFor investors like Buffett, having gold in their portfolio may not make sense, but for an individual investor, it might make some sense to have a part of his money in gold. The reasons are not far to see.

As an asset class, gold is a funny asset which is difficult to understand and value. It has no inherent value as such. Neither does it produce anything useful, nor does it go as input into producing anything useful in a meaningful way.

Gold is different from other metals or commodities. To some extent, commodities and metals have material value as inputs to something, and their prices can vary based on supply and demand cycles. You may not like the extent to which they may fluctuate, but at least there is some basis on which someone can say that it does not make sense to pay so much for a particular commodity, or that it is cheap at a particular price.

Gold is also different from stocks – which are productive business activities and have the potential to give you both dividends and capital gains if selected well. There are multiple ways in which you may value stocks or companies, but there is a clear economic rationale for each of these. Opinions may never reach a common point, due to which you have markets and all the related volatility, but at least one can have an opinion based on a method of valuing stocks or businesses on their own.

Gold is different from real estate too – in the sense that one can broadly estimate the cost of constructing a property including land and material prices as the base minimum value,  a potential rental income based on economic conditions as the minimum rate of income return, and add capital gains which are broadly in line with inflation as the long-term returns from real estate. It is possible to, at least, broadly value it.

It is even possible to value currencies – based on the country’s macro-economic situation and speculation on what might happen.

goldeggimagesBut Gold? How does one value it? It is just there. One can calculate the cost of mining it as the base – but it is far too low, and not increasing at the rate at which gold prices are. Gold has historically been a hedge against almost everything. Most of the time it is useless as a productive asset. It may at best match inflation, thereby growing at a rate at which currency falls. But in times of crisis, it tends to become a currency of its own. Specially when people want to sell all their stock and run (not exactly that – but are jittery in general), are not confident of real estate prices going up due to some reason, and also do not believe in the value of currencies due to huge economic problems, the thing they seem to rely the most on is Gold. For some reason, some of these fears have been around in the global economy for the past few years, and perhaps will stay on for a few more. So Gold has risen, and may keep doing so – till those conditions continue.

Individual investors should still have stocks, real estate and cash/fixed income as core to their assets. But have a bit of gold too – anywhere from 5% to 20% based on your preference. A chaotic environment favors gold, and if it subsides, you anyway have the other assets. Gold will help provide some stability when others are unstable. Purely as an insurance and for diversification, there is still some truth in grandma’s advice to buy some gold.

Are Markets Efficient and does it matter?

A lot of investing debate and styles of investing are supposed to emanate from this question. The roots of this debate are in an old financial theory called the Efficient Market Hypothesis – which says that all that is to know about a stock is reflected in its price at any point in time, so it is futile to analyze stocks as no one can do it. The very theory challenges human nature so much that it is no surprise that, depending on who you are and what your place is in the financial services industry, you are almost compelled to take a view on it – one way or the other.

marketefficient-garfield_dont_care_black_shirtBut for an individual investor, is it really relevant? Does it matter whether markets are efficient or not, or is it just another debate to confuse him? Again – like so many other things in investing, this may be a great question for experts to debate on, but for an individual investor, a wrong question with many right answers. For an individual investor, letting go on this debate on whether markets are efficient is the best choice. “I don’t know” and “It doesn’t matter” are the best responses. The answer to this question is said to determine whether you as an individual or a fund manager who manages your money can beat the market or not. Again – this is perhaps the wrong question. What if I decide that the markets are efficient and hence invest in Index funds, and then later (at the end of  a year or two) realize that there are lots of funds beating the Index? On the other hand, what if I decide the market are not efficient and hence invest in an Actively Managed fund or decide to manage my money myself, and then later realize that it has not beaten the Index? In other words, the market turned out to be not efficient, but so did my fund manager and my investing techniques!

So actually the prudent answer for an individual investor to the question on whether the markets are efficient or whether I or my fund manager can beat the Index is “I don’t know and it doesn’t matter”. Because the reality is, irrespective of whether they are efficient or not, it is practically impossible to predict in advance whether and/or which stock or which fund manager will beat an Index. Hence – “I don’t know and it doesn’t matter”. Well – I don’t know is fine, but an individual investor may ask why “it doesn’t matter”? It doesn’t matter because what matters more is to have an investment plan, asset allocation and re-balancing strategy in place. What forms part of those assets once you have a plan in place does not matter that much. So whether you choose an Index fund, or an individual stock or an actively managed fund within that asset allocation and re-balancing plan based on your answer to the question “Are markets efficient” may not matter much, at least if you are broadly close to market averages, and in so far as reaching your financial goals are concerned.

So – leave the debate of whether market are efficient to the experts to fight over and resolve. Post that, let them decide whether to focus on large caps versus mid caps; or to use fundamental analysis or technical analysis. For you as an individual investor, what matters more is a proper investment plan to reach your goals that is in line with risk profile, has the right asset allocation and re-balancing strategy in place, and the discipline to stick to it. Post that, you are free to keep deciding what assets to put into that plan, based on performance every year or every couple of years. If the markets turn out be efficient, you are free to move the actively managed fund and individual stocks out of that plan, and hold an Index fund.  If the markets are not efficient and you end up with a good fund manager (or if you yourself are able to beat the market) , good for you, as the stocks and funds you hold may beat the Index. And finally, if you realize that markets are not efficient, but your investment style or fund manager turn out to be equally inefficient :-), you are free to move that money to an Index fund!

So let the debate on Market Efficiency continue, and let the experts argue and make a case for your money. You as an individual investor are in an enviable position, because when asked your view, you can continue saying – “I don’t know and it doesn’t matter.”

Book Synopsis: The Intelligent Investor by Benjamin Graham

Have read “The Intelligent Investor” by Benjamin Graham many times, and every time I read it fully or even in part – I am amazed by the depth, clarity and advice laid out in the book, and relevant every bit today, irrespective of the fact that it was written in the 1940’s. Such a piece of Investment Advice is available nowhere else in such crisp form for the individual investor. It is almost like financial philosophy, akin to the ‘Bhagavad Gita’ of investing and finance for the individual investor – whenever you pick it, you learn a new piece of investment wisdom every time.

TheIntelligentInvestorIt is difficult to pick up the best parts from such a book which is so all-encompassing – it covers everything from definition of investment to specific criteria for stock selection. Here are some of the key takeaways from the book that are invaluable for the individual investor – many of which are well discussed, but still worth repeating and re-reading.

1. Investment versus Speculation: Graham presents a very clear definition of investing, which in his view, means any operation that on thorough analysis promises safety of principal and an adequate return. Anything not meeting these – i.e. there must be thorough analysis, must promise principal (he does not use ‘guarantees’ but promises), it must have adequate return (which he goes on to elaborate later), and finally, it must be like an ‘operation’ – business-like.

2. Bonds versus Stocks in Asset Allocation: He presents a simplistic 50:50 formula of allocation between fixed income bonds and stocks that works for most investors – giving a leeway of 25% on either side. i.e. at no time should the allocation of either stocks or bonds fall below 25%. The guiding rule is to keep re-adjusting this allocation when one component increases above a certain defined limit, like 60%, by selling the additional 10% of the increased component and buying the other. This does not guarantee the highest returns – but is a mechanical program that is most likely to practically work – simply because it advises selling and buying when it is counter intuitive, and “chiefly because it gives the investor something to do”.

3. Defensive versus Enterprising Investors: Graham makes a distinction between types of investors not based on risk taking abilities or age – as was traditionally thought. Return is not dependent on risk, but rather on the amount of intelligent effort that is put into an investment operation. The Defensive investor will place emphasis on avoidance of serious mistakes and losses, and seeks freedom from effort, annoyance and the need to make frequent decisions. The Enterprising investor will be able and willing to put in time and effort in the selection and tracking of securities that may appear to be better valued than the general market from time to time – which may help him achieve better returns than the market over long periods of time. Majority of investors would fall into the Defensive category. To achieve satisfactory results available to the defensive investor is easier than most people realize, to achieve superior results sought by the enterprising investor is harder than it looks.

4. The famous Mr.Market: This is perhaps the most valuable part of the book – on how to approach the widely fluctuating markets that an investor will face number of times in his investing life. Treat the market as an obliging, emotional partner in your businesses – i.e. the securities of which you own.  Every day, he tells you what he thinks of the value of the share of business that you own, and offers to buy your share at a price or sell you his share at a price. Sometimes his fears overtake him offering you rock bottom prices, while sometimes he is too excited about the future offering you great prices. The best part is he does not mind being neglected – he will come back again tomorrow if you neglect him. Your best interests are then served if you only transact with him if and when you agree with his prices – the rest of the time, it is best for you to neglect him and focus on the operations of your business.

In the book, Graham goes on to provide clear stock selection criteria for defensive and enterprising investors – with great examples to help stock evaluation practically. But more than those, the clear framework based on the above – definition of investment, asset allocation, the decision on type of investor, and the attitude towards market fluctuations – are most valuable for an individual investor to go about his investment operations.

Graham’s advice and wisdom are unlikely to make anyone rich in a hurry – perhaps only when one gets old. But the principles are timeless and practical, and unlikely to be available in such fullness anywhere else in today’s financial clutter. That alone makes it a case for the ‘best book about investing ever written’ in Warren Buffett’s words, to be a guiding light on your desk throughout your investing lifetime.

Why age based asset allocation is mostly wrong

I have often heard a lot of financial planners advise an asset allocation strategy based on the age of the investor – something on the lines of invest 100 less your age into equity or similar. While the broad logic of this strategy is that with increasing age, the capacity of an individual to earn himself out of a market crash reduces, purely age based asset allocation might, like many other things in finance and investing, be the right answer to the wrong question.


A student who has taken an education loan or a young married person saving for the down payment of a house can hardly justify investing 80% of his savings into equity, while a middle aged double income couple with their mortgage paid off or a retired millionaire with 20 more years of life would be foolish to invest majority of their net worth in fixed income. In fact, it would be risky for the youngster to put 80% of his savings into equity if he gets caught in a market crash when he needs the money for his house; and equally risky for the retired old man to depend on his fixed deposits to face 20 years of inflation.

I have found that asset allocation percentages need to be an output determined by life circumstances, net worth, current income, overall risk tolerance and age. Age can be a good determinant of some of the above, but it is too simplistic to assume that it is the only one. In many cases, it is not – and hence, it turns out that portfolios are more conservative or riskier than they should be. Historical data suggests that the possibility of losing money in equities over a 10 year period is quite low. Hence the equity percentage of the portfolio must largely depend on the ability of the individual to, more or less, forget his money and ride out a period of 10 years with no need for the money put in equity (and perhaps, put more into equity, if required during crashes). Now this ability is something that depends on factors like risk tolerance, current income, net worth, temperament and life circumstances, of which age is just one determinant.

The more you have of this ability, the more should your asset allocation be comfortably tilted towards equity. And age has, perhaps, little but not much to do with it.

The Financial and Psychological Benefits of Rebalancing

I have always felt that individual investors (or perhaps any investor to some extent for that matter) have never got a complete handle of the decision on when to sell. Traders or speculators mostly have a fixed target for profit or stop-loss, but investors never seem to enter a stock with a clear exit goal.


Rebalancing as a strategy might provide answers to solve this quandary – more than anything else for the individual investor. At a portfolio level, it provides you with a clear answer on when to sell, and, if required, it can be translated and implemented at an individual stock level also by more mature individual investors. Setting asset allocation limits at various levels in a portfolio can provide you with clear triggers on when to sell. So then, you stop asking yourself questions like – should I sell stock A at this price or wait for some time – questions which have no clear answers anyway. On the other hand, that answer is provided at an overall portfolio level, based on allocation limits.

For example, to provide a complex set of rebalancing rules, consider the following: If you determine that equity will account for 60% of my portfolio, and within that, large cap stocks will account for 50% of the holdings, and then no industry will account for more than 25% and no stock more than 10%, then it becomes easier to take decisions on what and how much to sell when these allocation percentages go out of whack. And if you are not a direct stock investor, but take your exposure through mutual funds, it gets much easier than the above scenario, assuming that your fund manager is dealing with the rest. Therefore, ‘I bought stock A at X, should I sell it now at this price Y’ becomes a wrong and somewhat irrelevant question, and thankfully so.

Of course, rebalancing is not a strategy that guarantees the highest returns. In certain cases, you may end up selling your winners, which in hindsight may not feel great. But for individual investors, who may have no particular reason to feel a sense of conviction about a specific stock, it provides a good way to reduce or manage risk. I do not think at a mathematical level, rebalancing has a very high impact on returns, but it sure reduces risk of excessive falls and locks in some of the profits. And if done correctly, it will also ensure that you buy equity at a time when every one is running away from it – in which case rebalancing affects your long term returns too.

An important effect of this strategy might well also be at a mental or psychological level – because an individual investor feels he is in control and has been smart to book profits when his portfolio grows and to buy stocks when they were low in price.

Therefore, less for returns, more for managing risk, and most importantly for the psychological advantage of getting emotion out of buy/sell decisions, rebalancing is a crucial strategy for portfolio management for individual investors.

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