When an asset class turns expensive, follow these six steps to optimize portfolio returns

Despite the recent market correction, equity indices are at high levels. Even with the recent rise in bond yields, government and corporate bond yields are still close to decadal lows, implying decadal-high bond prices. Notwithstanding its recent underperformance, gold has been the best performing asset class over the last three calendar years (2018, 2019, 2020). Most asset classes are close to their peak levels and are apparently expensive. So, how should an investor wade through such a market?

Here are six steps that you could use to navigate expensive markets.

Rebalance your portfolio: In the midst of a strong bull market, it is important for an investor to look at the existing asset allocation and analyse whether it has deviated sharply from the long-term objectives and risk tolerance. For example, a simple balanced 50 percent equity and 50 percent bond portfolio, starting out in March 2020, would be 65 percent equity and 35 percent bond now, as stock markets zoomed. This is a significant deviation in an investor’s risk profile and increases the loss potential. Thus, a prudent approach would be to trim exposures closer to one’s target asset allocation pattern.

Lower future expectations: Investors tend to extrapolate recent returns into the future. We believe equity markets are likely to transition to a more sustainable pace of returns in the coming few years, albeit with higher volatility on three factors. First, compared to previous cycles, equity valuations are at a much higher starting point today. Second, history suggests equity market returns normalise to high single or low double-digit returns post the recovery phase boost in the first 15-18 months after a recessionary market trough. Third, the lack of room for interest rates and bond yields to fall further suggests modest medium-term equity returns.

Be aware of the macro environment: Asset markets follow cycles heavily influenced by the macro backdrop. However, as investors, we tend to overlook the importance of macroeconomic variables on our investments. Being aware of the macro environment is crucial, as it helps investors not only to capture higher sources of growth, but also mitigate significant downside risks given that: (i) Most deep corrections (Index falls of 25 percent or more) are usually triggered by changes in the macro settings; (ii) The business cycle and policy environments could drive substantial changes among sectors and investment trends; and (iii) Analysing the macro backdrop can help identify structural multi-year and decadal themes.

Get past the FOMO syndrome: In bullish markets, it is likely that you would see some market segment or theme having a steep rise. Investors rue missing out, creating a sense of FOMO (Fear Of Missing Out), making them chase that trend to possibly disastrous results. Amos Tversky and Daniel Kahneman partially demonstrated FOMO through the theory of loss aversion. People have a strong tendency to avoid any losses, suggesting that losses are twice more impactful than gains psychologically. It is impossible to not get carried away, but having an investment strategy based on your goals, liquidity and risk appetite could go a long way in preventing you from succumbing to FOMO.

Diversify across assets and markets: Diversification is a key tool for investors to tide expensive markets. Diversification can be achieved in three broad ways: (i) Diverse allocation to different assets classes – equity, debt, commodities, cash, real estate and alternatives according to one’s asset allocation; (ii) Investing in international markets to avoid a single-market bias; and (iii) Spreading within an asset class across different market segments and styles within equities and similarly distributing one’s bond exposure across duration, credit and interest-rate sensitivity strategies. The basic tenet for diversification is to hold assets that have low-correlation with each other, so that during periods of weakness in a particular asset, the other can help offset some of the losses.

Average costs: Rupee cost averaging is a strategy to reduce the impact of volatility by spreading out your asset purchases over time, so that you're not buying the asset at high prices. Adopting a phased approach to investing in bull markets is very important, as buying lump-sum and holding for the long-term, is easier said than done, as investor behaviour shows that you are never sure of the right level to enter. Also, from a behavioural perspective, rupee-cost averaging takes the emotion out of investing. This is important as it reduces the risk of panic selling during periods of significant market weakness, which is the number one killer of long-term returns.