Think before you Leap !
This is certainly the best time to invest in market. The problem, however, is that most of us would have exhausted all our money when the market was at peak. By the time market crashes, most of the investors would have lost a good portion of their investment. This is precisely to avoid such situation, asset allocation makes sense.
Underpriced market: PE < 14
Usually a PE of less than 14 is taken as a sign of underpriced market. In an underpriced market, investors can invest 75% of the money in equity and equity oriented mutual funds and 25% in bonds and conservative mutual funds. Since the stock market is down, many good stocks will be available at very attractive price.
In March, 2009, the Indian stock market was underpriced. It gave humongous return in a year. A good number of investment turned multi bagger in a span of 1-2 years.
Fairly priced market: PE >= 14 & PE <= 20
You can identify fairly priced market by looking at the PE once again. The PE ratio of 14-20 is a signal of fairly valued market. This is the time when most of the stocks are fairly valued. Hence the potential of price appreciation is less.
The best strategy in such a market will be to rejig your portfolio and assign 50% of your money in equity or equity oriented mutual funds and 50% in bonds and conservative mutual funds. There could be other option such as investing 100% in balanced funds. The balanced funds invest equal proportion in stocks and bonds.
Overpriced market: PE > 20
Overpriced markets usually have a PE in the 20s. The market is all time high and the fall is imminent. The question is not of if but of when. There will be temptation to ride with the crowd. However, you should act just the opposite.
Since the market is overpriced, the potential of price appreciation is very low. You should invest least amount in equity and equity oriented mutual funds. The proportion, in an overpriced market, should be 25% in equity and equity oriented mutual fund and 75% in bonds and conservative mutual funds.
In Dec, 2007, the Indian stock market was at peak with a PE ratio of 27. The market hasn’t reached that even 4 years from then. Investors who invested major portion of their money in that period lost a large part of their investment. The PE graph shown below is for the period between Apr, 2007 and May, 2010.
