I suppose it is tempting, if the only tool you have is hammer, to treat everything as if it were a nail” – Abraham Maslow
On 16 January 2023, the Sensex reached its all-time high of 73,427 causing the market-to-GDP ratio, also known as the Buffet Indicator, to climb to 120%. Essentially, it measures the total stock market capitalization of a country relative to its GDP and is expressed as a percentage. This provides an indication of whether a country’s stock market is overvalued or undervalued in relation to the size of its economy. The 10-year average of this ratio is around 87%, suggesting a potential correction or bear market on the horizon. According to this measure, it implies that the market is running ahead while the GDP needs to catch up—putting the cart before the horse, so to speak.
While the market-to-GDP ratio is an important metric, it is not without its drawbacks. The most significant drawback is that it doesn’t consider certain economic factors, such as interest rates and inflation, which can significantly impact stock market valuations. Additionally, the composition of a country’s stock market may not accurately reflect the overall economy, especially in nations where specific sectors dominate the market. For instance, if the services sector dominates the stock market but represents a smaller portion of the GDP, this ratio would not provide a true picture. So, depending on which side of the spectrum one falls on, they would either follow this ratio religiously or not look at it in isolation. Either way, there are a few things that long-term investors can do that are not focused on a single data point but are more tied to their own behaviour towards risk. Before rebalancing their long-term portfolio, individuals should assess two things—risk appetite and asset allocation.
An important consideration when allocating capital for the long term is to understand one’s own risk appetite and then follow a long-term asset allocation strategy based on that. In many cases, individuals fall for heuristics and use ‘100 minus age’ as a yardstick for allocating into equity. However, they forget that the crucial aspect of personal finance is its personal nature and not a one-size-fits-all approach. Context matters significantly in personal finance, and generalization rarely provides effective guidance. In other words, what works as the sauce for the goose might not be the sauce for the gander in personal finance.
For example, a young investor, based on their previous experiences, might be very risk-averse. In Mark Twain’s words, they might behave like a cat that sat on a hot stove and then never again sat on the stove. This is because they consider notional loss in the equity market as a real loss and, due to their low corpus, might actually be right in allocating capital for the long term without setting aside funds for their short-term needs. On the other hand, a person close to retirement or a retiree might be very aggressive in terms of allocating capital into equity. This could be because they have seen the benefits of managing risk for future rewards. It might also be because they have accumulated a large corpus during their working years, which could take care of their needs in retirement and beyond. Thus, they are looking at wealth generation and are willing to take higher risks for higher rewards.
Therefore, long-term capital allocation decisions should be personalized based on individual risk appetite rather than generalized based on the general population in similar demographics.
Additionally, risk appetite is a moving target as individuals experience various ups and downs in life, and their perception of risk may change due to those situations. Consequently, their asset allocation should be adapted to align with their risk appetite at that particular point in their life. Therefore, individuals must assess their risk appetite and then rebalance their long-term portfolio asset allocation if it goes beyond their tolerance range. For instance, someone might have started with a moderate allocation to equity, but over time, after experiencing multiple market cycles, they might be more open to taking risks in their long-term portfolio.
Alternatively, it’s not necessary that one’s risk appetite has changed, and one is in control of their behaviour towards it. As is happening now, market returns could also change the asset allocation for an individual beyond his tolerance level. This would again necessitate a change in his asset allocation to bring it to a level with which he is comfortable. The market would do what it does; it’s not necessary that you need to act upon its every whim and fancy. As Ben Graham once said, “In the short term, the market is a voting machine but in the long term it is a weighing machine.” So weigh your long term options and then make your asset allocation decision.
Abhishek Kumar is the founder of SahajMoney.
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Published: 24 Jan 2024, 10:19 PM IST
