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Should you sell off your equity funds since the market is overvalued?


16 Jul 2021 - Contact Sayan Sircar
5 mins read

The market cannot be predicted but lessons from history and some basic rules can help you to decide what to do.

Thinking about overvalued markets

Table of Contents

Introduction

As Nifty reaches a lifetime high every week (the last was a week back on 7-Jul-2021), many investors are fearful of an impending market crash. This is a classic example of loss-aversion where the fear of probable loss is stronger than the chance of getting future gains.

Peter Lynch famously said,

“Far more money has been lost by investors trying to anticipate corrections than lost in the corrections themselves.”

This “loss” is due to missed opportunities - the market moves up while the investor either

  • waits on the sidelines with cash
  • or pulls out money while the market goes up further

or, alternatively, there can be a benefit in waiting in case the market actually corrects.

There are multiple nuances to this and we will explore all of them below, including a plan to deal with the current scenario.

Is the market overvalued?

Market return

We have all seen the bull market since the lows of the Mar-2020 COVID-19 crash and the corresponding rise in the equity market across all capitalizations, and most sectors and themes.

Market overvalued

This has also given rise to the fear of overvalued markets as shown by P/E charts for example and the fact that there have been lifetime highs 47 times since Mar-2020 in the Nifty 50.

What happens if you invest at market peak?

Lifetime high chart

There have been 483 cases of Nifty 50 reaching a lifetime-high (highest value ever on that date) from Jan-1993 to Jul-2020. There has been a further 47 such cases from July 2020 to Jul-2021. This chart shows the Nifty price level (in log scale) in that period and each life-time-high is shown with a yellow dot. The red dots show the 1-year return from the date of the lifetime-high value (axis on the right side).

Lifetime high distribution

The short answer is nothing really bad happens after investing at the lifetime-high level. From the 483 cases in the chart, the average 1-year return in that date range came at 10%. There is a 66% probability (283 out of 483 cases i.e. 2 of 3) where the return has come positive (24% average) and of the 1 of 3 (145 of 483) cases, there has been a negative return (average -17% return). The distribution is shown in the figure above.

This means that there is a 2/3 chance of regret, based on past data, that the market will go up from the current high levels while you wait on the sidelines. In finance, a probability greater than 50% indicates a trend that should be followed and not be bet against. This also shows what is intuitive (highs lead to falls) may not be always supported by data.

What happens if you invest at market peak AND the market falls?

Lifetime high distribution after 1 year

If we look at the 1-year return exactly after one year has passed from the life-time-high in the cases there was a negative return (i.e. in the 145 cases ) we see that there were 20 cases with negative 1-year return in the 2nd year and 125 cases with positive 1-year return in the 2nd year. This means that out of the 483 lifetime-high cases there are only 20 cases where there have been consecutive negative year-on-year returns i.e. a probability of 20/483 = 4%. So it is unlikely (only 4% or 1/25 chance) that if you invest at life-time-highs, you will make negative returns two years in a row.


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Where are you in your life stage of investing?

Investors should be aware of sequence of return risk when investing.

If they are at the beginning of their investment journey, a likely fall will be good for the long term portfolio

  • the current corpus is much smaller than what it will be in the future
  • any investments today, after the market fall will grow from a lower base

Investors in the accumulation stage should continue investing if their goals are not funded.

If you are at the beginning of retirement, however, a market fall will damage the portfolio significantly. Investors in this life stage should review their retirement buckets and rebalance them in case the allocation is not proper for this stage.

Are your short term goals properly funded?

If you have goals due in the next 3-5 years, they should ideally be in cash i.e. safe investments in a bank FD or similar assets. If there are a lot of gains in equity, this is a good time to rebalance to fill the cash bucket to ensure that there is enough money held in safe assets for these goals.

What is the signal from your asset allocation?

Each goal should have a suitable asset allocation with its own equity to debt proportion. If the market has rallied, then it is likely that asset allocation is now equity heavy. This is a good time to invoke corridor based rebalancing (if 60:40 is the target and allocation is now 65:35 say then rebalance to debt). If the crash has already happened, it is a trigger to rebalance from debt to equity.

Conclusions

Markets cannot be predicted but investors can

  • learn from historical data that life-time-high levels do not automatically lead to losses
  • take a decision based on the life-stage
  • asset allocation should be used to determine the next steps by rebalancing
  • investments while in the accumulation phase should be continued

Please contact us using the links below to get a copy of the Excel sheet used to generate the numbers in the post (2021-07-16-shouldYouSell.xlsx).

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