When you do financial planning, your broad philosophy is three fold. Firstly, use equities to create wealth in the long term. Secondly, use debt to bring stability and regularity of income to your portfolio. Finally, use liquidity to make funds available for emergencies and for short term opportunities. In addition to these, you can also look at gold and commodities as a separate asset class and make a small allocation, but that is purely optional. If you look at the financial planning statistics, you will find the dominant allocation to equity and debt and a small allocation to liquid assets. The big challenge for you in financial planning is managing risk. When you create your financial plan, the market scenario is not going to remain static over longer periods of time. As the risk profile and the return profiles change, you need to constantly keep tweaking your financial plan to manage this risk. Let us look at five such market risks and how to handle them.
Shifts in commodity risk
A shift in commodity risk is not only going to impact your commodity portfolio but also you equity portfolio. For example, in the Indian markets the weightage of oil, steel, aluminium, minerals and ore is quite significant in the Nifty and the Sensex. Therefore, when the commodity markets go into a down cycle or an up cycle, there is a clear collateral impact on equities too. What should be your strategy then? Ideally, if the market is at the peak of a commodity cycle, it is a sensible decision to reduce exposure to commodity stocks and commodity oriented funds. This money can be reallocated either to debt funds for a short period of time or can be reallocated to equities that are less vulnerable to commodity shocks. The reverse strategy can be employed when the commodity cycle bottoms out.
Systematic risk of equities
Systematic risk of the market is measured by Beta. A stock with a beta of more than one is classified as an aggressive stock while if the beta is below 1 it is classified as a defensive stock. In the past few months we have seen the beta of stocks in the FMCG space and the auto space go up sharply. At the same time stocks like IT have become less vulnerable to shifts in the market sentiment and they have seen a downward revision of beta. You need to monitor your portfolio for the overall beta as that is impacted by the betas of individual stocks. Based on your target equity beta, you can tweak your equity funds portfolio accordingly.
Unsystematic risk of equities
Unsystematic risk is the counter view on beta. Unsystematic risk represents the company specific and industry specific risks that are either making a stock more risky or less risky. This has important implications for sectoral funds and thematic funds. For example, if you have a small exposure to pharma funds and you find the Indian pharma companies under pressure due to global competition and thinning margins, you can take a call to shift out of pharma funds and perhaps get back into diversified funds. Similarly, a reduction in unsystematic risk like currency weakness for import oriented stocks is a major positive and lead to reduction of unsystematic risk.
What if there is an economic upturn
An economic upturn is not about systematic risk or unsystematic risk alone. It is about overall macroeconomic buoyancy. It includes a spurt in agricultural output, industrial output, services output etc. Quicker production means quicker sales and that translates into higher EBIT and higher PAT. That is going to reflect in performance of equities very soon. You can look to increase your exposure to stocks that are likely to benefit from higher demand, higher products, turn around in the capital market cycle etc. Your equity portfolio within the financial plan can be tweaked accordingly.
What if there is an economic downturn
That is where things get slightly more complicated. Things are much simpler for your financial plan when it is an economic upturn. The markets will generally do well and your equity diversified funds should outperform peers by a margin. The problem in economic downturn is that the damage can be broader and also the damage can have a chain reaction. For example, equities may lose value rapidly. During the downturn of 2001 and 2009, Indian equities corrected between 40-60%. That is deep damage to your financial plan. Even bond tend to become volatile and hence debt funds also tend give volatile returns. The answer may be to temporarily park funds in liquid funds or ST/UST funds and then look to use the liquidity when the equity opportunities arise. It is in such circumstances that the power of a phased approach (SIP) works best in favour of your financial plan.