There is many a SLIP between the SIP and the LIP

The short term route to long term SIP investing..

The new SIP culture..

One of the best things to have happened in recent times, is the advent of new fintech firms like Kuvera, Paytm Money, Scripbox etc. These folks are doing a great job and hopefully should be able to build the culture of monthly savings into equities (read as SIP) for the rest of us.

While a lot of people are starting their SIPs, I am also worried that somewhere we might not be setting the right expectations.

Most of these firms primarily provide returns and ratings. Now if I were you, naturally I would be anchored towards a higher return fund.

This fund has the highest return over the last 5 years. The fund must be doing something right. Let me invest..

And then reality strikes. As you watch your investment month after month, the returns seem to be a far cry from what you expected.

For example, you can check how my live SIP portfolio has moved in the last 8 months here.

Oops. This is not what you thought and you stop your SIPs just at the wrong time…

Unfortunately, the short term is a lot more different that the long term.

Higher returns have a cost. The cost is paid emotionally.

You have to get used to the uncomfortable feeling of seeing your hard earned money go down and up at regular intervals.

Unless and until we have our expectations set right for the short term, we won’t be able to survive the long term where the actual magic happens.

The idea of this post is to help you understand the short term pain which needs to be endured to experience great long term returns.

So how do we go about setting the right expectation for short term volatility?

Two parts of an SIP

An ongoing SIP has two components:
1) The part of the portfolio that has already been built via SIP
2) The incremental SIP that will get added

For eg, assume you invest, Rs 10,000 every month for the next 10 years in a few equity funds and the returns are 15% annualized. This is how your portfolio would have grown.

Untitled.png

The blue bar represents the part of the portfolio that has already been built via SIP. The green bar represents the additional SIP flow for every year.

The usual argument in favor of an SIP is that, as we invest our money across several months, even as equity markets go up or down, we end up averaging our buying price. And hence the notion that, we don’t need to be worried about market ups and downs, as the SIP will take care of it and in fact take advantage out of volatility.

A quick glance at the above chart and you know what we are missing.

While the above logic works well in the initial years, as time progresses, the incremental amount which gets invested via an SIP over a year becomes small compared to the overall portfolio.

And hence, while the incremental amount is averages out equity ups and downs across 12 months, the larger component i.e your existing portfolio (which is already built via past SIPs) is completely exposed to equity markets ups and downs.

So to set short term expectations, we need to build expectations for both these components separately and add it up.

But how do we do this?

And even before that.

What the heck is short term?

Earlier I used to consider 1 year as a period for measuring short term ups and downs. But extensive research done by the US firm Riskalyze points out that 1 year is too long for most investors to stay calm during a market fall and most of the decision making is done on a 6 month basis.

So we shall use 6 months, to set our near term risk expectations (read as the range of ups and downs to be expected).

Component 1: Portfolio which is already built

The detailed explanation for setting 6 month expectations, has already been discussed in our earlier post here.

Based on this, we had found that for any 6 month period, 95% of the times, a 100% equity portfolio ended up with returns anywhere between -26% to 52%.

Now obviously we won’t be able to predict where exactly in the range the portfolio returns would be over the next six months. But the key idea is that, even if the portfolio falls 26% over the next 6 months, this is expected to be a part of the normal behavior of the portfolio and we should be ok with it.

That being said, this outcome range covers only for 95% of the scenarios which we can quantify. There is about 5% of the risk that we can’t quantify. The outlier ‘black swan’ type events we saw in 2008 are a good example.

The same 100% equity portfolio was down around ~60% during the sub prime crisis of 2008!

So our expectations should factor in a normal scenario of upto 26% fall over a 6 month period which may happen at regular intervals. At the same time, we must also be aware that the fall can go up to 60% or even more during rare crisis type scenarios.

Component 2: Next 6 month SIP

For a 6 month SIP of Rs 10,000 (i.e an investment of Rs 60,000 in total) – the portfolio value for 95% of the times has ended up in the range between Rs 50,000 to Rs 80,000.

The worst ever value has been at Rs 40,000.

The above value has been calculated using Nifty (from 1990)

So using this we can calculate for different amounts.

For eg if you have a Rs 20,000 SIP, then you can expect the portfolio value to be anywhere between Rs 1,00,00 to Rs 1,60,000 in the next 6 months. This uncertainty is the emotional cost that you are required to pay for getting long term SIP returns.

SIP short term volatility expectation formula

This is how you can set expectations for the next 6 months:

95% of the times it will be in the range of

Lower Range =

(100%-26%) * Component 1 + (SIP Amount/10,000)*50,000

Upper Range =
(100%+52%) * Component 1 + (SIP Amount/10,000)*80,000

Real Life SIP Portfolio

I run an SIP of Rs 30,000 every month in two equity funds. This was started on 05-Aug-2018 and the details on the live portfolio is available here.

Going by our logic, we should be ok if our portfolio value is between Rs 1,50,000 to Rs 2,40,000.

After 6 months, on 05-Feb-2019, the value of my portfolio was around Rs 1,75,000 (I have not included the Rs 30,000 invested on that day). While my portfolio was in loss by Rs 5,000, this was within the expected volatility range. Nothing to panic. My portfolio behavior was as per expectation.

Now how do we set the next 6 month expectation?

As per our formula, the 95% return range outcome would be

Lower Range: Rs 1,75,000 * (100%-26%) + Rs 50,000 * (30,000/10,000) = 1,29,500 + 1,50,000 = Rs 2,79,500 (let me round it to Rs 2.8 lakhs)

Upper Range: Rs 1,75,000 * (100%+52%) + Rs 80,000 * (30,000/10,000) = 2,66,000 + 2,40,000 = Rs 5,06,000 (let me round it to Rs 5 lakhs)

So in the next six months, that is on 05-Aug-19, I would expect my portfolio (actual investments of Rs 3.6 lakhs) to be between Rs 2.8 to Rs 5 lakhs. This would be considered normal behavior from my portfolio.

If there is a black swan event, then my portfolio can fall even more than this. It is reasonable to expect one major crisis event every ten years.

I have a 10+ year time frame for my SIP. This means I have 20 six month periods to stay invested. Even if I lose out on a few periods, going by history of equities, majority of six month periods will be in my favor and hence I get to experience better returns over the long run.

In a similar manner, you can start building reasonable volatility expectations over the next 6 month period for your SIP portfolio.

The key idea is to stay for long term returns, one six month period at a time!

Summing it up..

The hope is that with the right expectations you will confidently navigate the short term volatility, continue with your SIPs and eventually end up experiencing awesome long term returns!

Do share your feedback and let me know if it works for you. You can also mail me at rarun86@gmail.com.

Happy investing as always! 

If you loved this post, share it with your friends and don’t forget to subscribe to the blog via Email (1 article per week) or Twitter along with the 6000+ awesome people. Look out for some fresh, super interesting investment insights delivered straight to your inbox.

You can also check out my other articles here

Disclaimer: All blog posts are my personal views and do not reflect the views of my organization. I do not provide any investment advisory service via this blog. No content on this blog should be construed to be investment advice. You should consult a qualified financial advisor prior to making any actual investment or trading decisions. All information is a point of view, and is for educational and informational use only. The author accepts no liability for any interpretation of articles or comments on this blog being used for actual investments.

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Knowing your Risk won’t save your Portfolio in the next market fall. But this will..

10 minute read

In our last post here, we had explored a new intuitive framework to help us understand our risk tolerance and how to adjust our asset allocation based on the risk which we can take. The overall idea was to get a realistic sense of what is the downside which we are willing to tolerate in the short term to get decent long term returns.

With expectations being more realistic, there is a better chance that we stick to our portfolios during both ups and downs and hence enjoy better outcomes over the long run.

For almost a month, I have been a little obsessed with this framework and it’s immense scope to improve our investing behavior. A lot of readers have mailed me on how useful it is and also some amazing questions and suggestions on how to improve it further. I will be writing about the new revamped framework in the coming weeks. Thanks to all you wonderful folks.

However once we cling on to an idea, there is always the risk of confirmation bias. I suddenly keep looking out for views which confirm to this idea. So to break this bias of mine and check if this framework will really help us handle declines better, let me try and argue from the other side.

Why this new framework of quantifying risk using a 6 month returns range (with 95% probability) still has some unaddressed issues?

For finding this out, let me take myself as an example.

Given the relatively small size of my current portfolio compared to my future earnings potential (read as human capital) and also my age, I have a very high risk tolerance and hence a 100% equity portfolio.

For the purpose of illustration, let us assume I have a portfolio of Rs 50 lakhs. I am ok to see a loss of up to 30% or Rs 15 lakhs in my portfolio for the next six months. Not that I would like it, but given the attempt at maximizing long term returns, this is an emotional cost I am willing to pay.

With this as the backdrop, let us check out my thought process if a real decline were to happen.

Eavesdropping my brain in an imaginary market decline..

Post the recent attacks across the India-Pakistan border, there is significant uncertainty over the relationship between two countries.

Hypothetically let us assume, both countries decide to go for war (honestly if this happens, we have far more things to worry than our portfolio and I really wish nothing like this happens).

How would we handle our portfolios?

While I have told you that I would be comfortable with a downside of up to 30% or Rs 15 lakhs in the next 6 months, suddenly when an event such as this happens, my narrative starts to change.

“Hey these are not normal events. This is a serious problem. The equity markets will definitely get hit. Why should I wait till a 30% fall. Rather I will take out the money from equities now and enter later”

Oops! This is our Framework-meets-reality moment!

Let us assume, my advisor puts sense into me and says “Hey, it is impossible to predict markets in the short run. I know it is tough to be calm during these periods. But you had agreed that you were ok with upto 30% or Rs 15 lakh decline in a 6 month period. These are precisely those sort of periods which test you. Kindly hang on.”

I listen to him.

But unfortunately as I had predicted the market has started to fall. It is already down -4%.

A week has passed. The markets are further down to -9%.

Me: “WTF! If only I had listened to myself. I would have saved Rs 4.5 lakhs. That’s like almost the cost of a car.”

My Advisor: “While things are definitely not easy and I completely get it. We are still within your chosen comfort zone. This level of risk was agreed upon as the normal behavior to expect from the portfolio. Our plan is on track and if we stay with our plan, we should be fine in the long run”

Me: “Your advice has already cost me Rs 4.5 lakhs in just 2 weeks! I still think we need to pull out money as this war is going to have a significant impact on the economy and the markets”

My Advisor: “It is impossible to predict the short run. This uncertainty of not knowing what will happen, is precisely the emotional cost that we have to pay this equity asset class for long term returns. I think we should continue to stick to our plan”

Me: “Ok..Whatever”.

I feel like he is a broken tape with the same in the long run it will all be fine bu** sh**.

So I finally decide to do nothing and stick to the plan.

As my bad luck would have it, I am down again to -15% in the next two weeks. That is like a whopping Rs 7.5 lakhs in 4 weeks.

Enough is Enough. I am pulling out my money.

It proved to be a great foresight. The portfolio was down to -20% in the next week. Phew, I have saved atleast Rs 2.5 lakhs.

But wait. The market has suddenly gained 10% in the next week. Should I get back in or wait?

It has again gone up and now its just 5% below the levels at which it started to decline. There is unconfirmed news that due to international intervention both the countries have agreed to stop the war.

Oops! Let me get back in immediately.

But early morning, Pakistan troops have again raided one more village near the border. The war is not yet over. The markets start to crash again.

Now what do I do?

This is exactly how even a good portfolio invested after clearly knowing our risk tolerance can still go for a toss.

It all boils down to this single question.

Do you believe you can predict the market movement over the short run?

Each and every decline has a new reason. Sometimes its oil, sometimes its sub prime crisis in US, sometimes its the currency, sometime its the dotcom bubble, sometimes it’s a war etc.

To predict the markets, you will need to be an expert in almost everything which can go wrong in the world. You need to have a view on how exactly things will pan out.

Add to it, if you move out of equities you also need to get back.
When do you get back?

This means you will not only need to be an expert in almost everything which can go wrong in the world, but also an expert on how and when these problems will get solved.

And if you thought that’s about it, hang on. You have to go one step further and also predict how millions of investors will perceive and react to these!

This means, when markets start falling due to some event, it is impossible to know if the event and the fall is a regular one or the rare black swan types. For each and every event, there are several possibilities on how it could have played out. Unfortunately when we look at it in retrospect, it is just one version of history that we get to witness.

In hindsight, we are able to weave a nice narrative on the cause and effect for the market move and hence start to think that future market moves are predictable.

If you really think about it, this belief that we or someone can predict the markets is where the actual problem is.

My own prediction debacles..

I am no saint. To be honest, just like all of us I too started out with the notion that I will be able to interpret the events and predict the markets.

In 2013, around May the US Fed had announced that they were planning to gradually reverse their quantitative easing programme (read as no more money printing).

The Indian equity market was down by 10% and the Indian currency had moved from 53 to 66 levels! India was classified as one among the FRAGILE FIVE.

SENSEX    BSE Sensex  Sensex Index  Live Sensex Index  Sensex Stocks.png

It was the “sh**-hit-the-ceiling moment” for me.

I poured over various brokerage reports and got a clear sense of the issue and how it will play out (or that’s exactly what the overconfident me thought)

I predicted that the markets will obviously fall more and exited a part of my equity allocation with the plan to get back. You know what happened next.

The markets recovered!

By the time I entered back all my stocks were above my selling price 

I was almost about to make the mistake again during demonetization. Given my earlier 2013 experience I thankfully stuck on for sometime. But if you really think about it – the whole thing was unprecedented.

Most of the articles and reports really scared the daylights out of me. Every part of my brain was shouting, “Markets will go down! Sell first. We can think later”.

Now to be fair to the reports, what played out was possibly one among the many equally possible outcomes. The reports, most of them did have a logical case and could have easily turned out the way they predicted.

To predict or not?

The key learning was this – the world is extremely complex. To make sense of each and every possible crisis situation and predict how millions of investors will interpret that is beyond my level.

So, I personally belong to the camp that

“To predict what will happen to the markets in the short run consistently is almost impossible.”

Till date unfortunately, while there a few who got it right once or twice there has been no evidence of someone who has done it consistently.

If you don’t trust me check out how our Indian fund managers fared in their prediction of 2008. Link

Its not just the Indian fund managers, even the global investing giants too haven’t been too successful in this endeavor. Link

Now before the next fall occurs, you need to clearly decide on your stance as far as predicting market is concerned. This will be the key determinant to how we actually handle the next fall.

The worst time to figure this out is when the market fall actually happens. We need to do it now, when we can think clearly and without any pressure.

If you think you can predict the world and the markets, then this whole risk tolerance framework where you will have to put up with some decline is of no use to you. You can rather easily move out before the crash and get in before the rise.

But if you are convinced that predictions are too difficult, now suddenly our risk tolerance framework (i.e the 6 month range of returns) starts to make a lot of sense.

Since you have no way to know what the market will do or which event will hit us when, the only thing under our control is to decide the degree of fall we need to tolerate for getting higher returns. It may be 10% or 20% or 30% etc. By choosing a corresponding asset allocation we can control our risks to a great extent.

This being said, the degree of risk within the asset class is also impacted by valuations. Our existing framework can be improved further by adjusting asset allocations based on valuations. While valuations won’t let you time markets precisely, they can help in improving long term returns and reducing the 6 month volatility range.

In the next post, I will discuss, how we can create our what-if-things-go-wrong plan based on valuations.

This combined with our humility that we can’t predict and our new risk tolerance framework should keep us in a much better position to handle the next fall.

Till then, happy investing as always! 

If you loved this post, do share it with your friends and don’t forget to subscribe to the blog via Email (1 article per week) or Twitter along with the 6000+ awesome people. Look out for some fresh, super interesting investment insights delivered straight to your inbox.

You can also check out my other articles here

Disclaimer: All blog posts are my personal views and do not reflect the views of my organization. I do not provide any investment advisory service via this blog. No content on this blog should be construed to be investment advice. You should consult a qualified financial advisor prior to making any actual investment or trading decisions. All information is a point of view, and is for educational and informational use only. The author accepts no liability for any interpretation of articles or comments on this blog being used for actual investments.


Becoming a Long term Investor, One Short term Decision at a Time

10 minute read

The fat loss challenge..

I earlier used to workout with a fitness community in Chennai. Every year in January, they had an interesting challenge called “Fat Loss Challenge”.

Basically, everyone who registers for it, is given a 9 point checklist which you will have to answer and adhere to everyday. The checklist takes care of your diet (are you having enough starch, vegetables, proteins, avoid sugar, avoid wheat, avoid junk etc), exercise (45 minutes everyday), and sleep (more than 7 hours). Based on your answers, you are given a score. This goes on for around 2 months post which your results are measured. 
 
While the program was the same for everyone, the results were not. Few had phenomenal results and lost weight like crazy, most had decent weight loss and some saw hardly any change as they couldn’t adhere to the plan.
 
Now the interesting part is this – none of us were surprised by the results!

The expectations were realistic right from the beginning, as all of us knew that adhering 100% to the plan each and every day is going to be difficult.

Different people found different things challenging. For some it was adhering to 7 hours sleep. For some it was avoiding sugar and so on.

So most of us, ended up having different levels of adherence and scores, based on our own personal constraints and preferences. All of us intuitively understood that, while the plan was great, to stick to the plan was where the actual challenge would be.

The not-so-easy part of making great returns..

Let us now come back to our world of investing. Returns whenever they come, receive insane marketing and media coverage. We go “wow” on seeing the mind blowing historical performance and immediately buy the fund. We expect the same returns to continue.

Yet, strangely once we buy a fund, we don’t seem to get similar results.

If a fitness program promises fat loss, we understand it’s not going to be easy. But when it comes to higher returns somehow we think once we buy the fund, the returns are a given.

Now here is where the challenge really lies.

When it comes to investing, the “not so easy” part of getting good returns is unfortunately also “not so obvious”.

green leafed plant

We use a sophisticated jargon to represent the “not so easy” part – RISK. 

You clearly see and understand RETURNS. You easily get it.
But this RISK..
It’s too vague. What and where the heck is it?

Me and my industry need to take the blame as we were talking a language which you obviously didn’t relate to. 

So, how do we make sure all of us truly understand the “not so easy” part (read as risk) so that the return expectations are realistic?  

Thankfully for us, a US firm called Riskalyze has developed an awesome yet simple solution. I will use their concept as an inspiration and explain my Indian customized version.

Great expectations…

Everything starts with this – a huge expectation mismatch between the investor and the nature of product returns.

Whenever someone asks the most logical question –
“What will be my expected returns in equity”

Around 14-15% goes the immediate answer.

But here is the shocker.

Sensex in the last 38 years, has not ended a single year between 14-15%!

The correct answer is “I don’t know”

But a more empathetic and helpful answer would be “I don’t know. In the short run it is impossible to predict returns and no one has ever been able to do it till date.  That said, if we’re thinking long term, equities will work out and going by history can give you decent returns in the range of 13-15%”

That’s great. You jump into equities. It’s six months and the portfolio is down 10%. You are furious. Where is your 15%+ returns?

While everyone asks you to focus on the long run, if your portfolio is down 10% in 6 months, you are obviously mighty pissed.

Why in the world would you hang on for the next 10 years?

So the harsh reality is that,
the long run is inevitably made of several short runs.

While long term is where we want to focus on, psychologically, we are investing for a large number of much shorter time periods.

If you are not able to manage the short run then the long run is a useless target.

And the short term decisions we make along the way will have a profound long term impact.

Takeaway: All long-term investors are made, one short term decision at a time.

This means, we have to make ourselves comfortable with short term first!

How do we do this?

Solving for long term via short term..

1.What would be the ideal short term period in which investors usually evaluate their portfolios.

My sense was it should be 1 year. But Riskalyze from its research has figured out that one year is just too long for a normal investor to “hang in there” if they are in the middle of a falling markets and worried about further losses. At the same time, a 3 month period is too short.

6 months was the sweet spot!

Now that we have decided to handle long term via a series of 6 months,
A 10 year long time horizon, suddenly becomes 20 short term – 6 month periods instead!

2.How much fall are we willing to put up with in a 6 month time frame beyond which we might find it extremely difficult to stay with 
the plan?

It is better to use actual values instead of percentages. Think about it – the same 50% fall on a Rs 10 lakh portfolio feels a lot more different in a Rs 1 cr portfolio.

So for a 1 cr portfolio, you may think you can withstand upto Rs 20 lakhs decline or up to 20% in the short run.

Any fall more than this, you might find it extremely difficult to hang on and might be emotionally driven to sell off . 

In technical terms this is called your “risk tolerance” (the level of decline which you are willing to tolerate for a chance at higher returns)

Now that we have defined your ability to handle declines (or risk tolerance) in plain English, we have to check if your portfolios are aligned to your risk expectation.

To do this, I have provided the representative 6 month outcome range (with 95% probability) for different asset allocation between equity and debt.

The workings have been calculated for the last 18 years with a large cap fund (Franklin India Bluechip Fund) representing equity allocation and a short term fund (IDFC Bond Fund – Short Term Plan) representing debt allocation.

The table above captures the 6 month range of returns which occurred 95% of the times. So you can read the table as, over the next 6 months, there is a 95% probability that the returns from a 70% Equity + 30% Debt portfolio will be between -17% to 30%. This range describes the “comfort zone” for the particular asset allocation.

In other words, if the investor chooses this asset allocation, he should be ok with the portfolio returns being anywhere between -17% to 30% over the next six months. This volatility is not a bug but a feature! 

So based on the above comfort zones, you can align your asset allocation to your risk tolerance.

Conversations on risk..

Now armed with this new frame of viewing risk vs returns, let us see how our investing approach changes via an imaginary conversation.

Raj: Hi Arun, I have Rs 1 crore to invest and I guess I wouldn’t be needing it, at least for another 10 years. I am looking for high returns and want to go with a 100% equity portfolio. What kind of a performance can I expect?

(with great difficulty I resist the temptation to anchor to the sacred 15% returns 🙂 )

Me: Great! As you know, higher returns always come with the caveat that we need to pay the corresponding cost via higher short term ups and downs. Just to make sure your portfolio is aligned to your risk expectations, what is the maximum amount of fall that you would be willing to tolerate in 6 months ?

Raj: Fair enough, I understand that my portfolio will go up and down often. But I guess a maximum of Rs 15 lakhs loss (i.e 15% of portfolio) is what I will be ok with in the next 6 months. Anything more than that, I am not sure if I am upto it..

Me: Sure. I completely get it. But I guess there is a slight mismatch in your risk expectation vs the risk present in a 100% equity portfolio.

If we go for a 100% equity portfolio, your portfolio’s short term returns i.e 6 month returns for 95% of the times has ranged anywhere between a Rs 26 lakhs loss to Rs 52 lakhs profit.

Now to be brutally honest, I nor anyone has a clue on where exactly in this range your next 6 month return would be.

But if your portfolio is down say 25% or up 40% in the next 6 months, this is something which I would consider as the normal behavior to be expected from this portfolio. As long as it is within the range, you should be ok with it. This is the risk that we are signing up for, knowing well in advance.

Here is the best part – it is completely under your control whether you want to take this level of risk or not.

You had indicated that you are not comfortable having a short term decline of anything more than Rs 15 lakhs in the near term which unfortunately is a part of the normal behavior of the 100% equity portfolio.

A 60% Equity + 40% Debt is more in line with your risk expectations where the 6 month – 95% probability range of outcomes is between -13% to +33%.

This also means, we need to lower our longer term returns expectation from the earlier 13-14% for a 100% equity portfolio, to around 10-11% for a 60 Equity:40 Debt portfolio. (conservative assumption of 13-14% in equity and 7% in debt)

As you can see, there is an obvious trade off between the amount of risk and return we can expect. While there is nothing wrong with both the portfolios, as with everything else in life, we need to choose our tradeoff. If you need higher returns then you must take higher risks (read as short term pain) and vice versa.

Raj: Oh! I never thought about it this way. I thought a 15% return was easy to get in equities. So you are saying I must be ok with the possibility of a Rs Rs 26 lakh decline to a Rs 52 lakh gain in any 6 month period.

Phew! I really think Rs 26 lakhs is a significant amount for me. I don’t really think I am up for it. Let us go with your suggested 60% Equity:40% Debt portfolio. I shall compromise on my return expectations.

(How I wish this was a real life conversation. I would have fainted right away in happiness)

Me: So just to make sure we are in the same page, in the 60% Equity:40% Debt portfolio your near term 6 month outcome range is anywhere between loss of Rs 13 lakhs to gain of Rs 33 lakhs.

We shall be reviewing your portfolio in 6 month blocks and most of the times we would expect your portfolio returns to fall in this range. This is the expected normal behavior and exactly what we have signed up for. As long as your returns are in this range, we will show a thumbs up to each other and agree that the portfolio is on track.

Assuming ten years is your holding period, we have 20 six month blocks to be reviewed.

But, let me also honestly tell you that this outcome range covers only for 95% of the scenarios which I can quantify for you. As you know, there is about 5% of the risk that I can’t quantify for you, the outlier ‘black swan’ type events we saw in 2008 are a good example.

These are not events, which may or may not happen. These black swan events will definitely happen sometime in the future but are very rare.

To give you a sense of what to expect during those crisis scenarios let us check how the portfolio would have done during 2008.

In 2008, the 60% Equity:40% Debt portfolio was down by around 24% or Rs 24 lakhs which is a lot higher than your comfort zone of 15 lakhs or 15%. But a 100% equity portfolio was much worse. It was down by almost 48%!

Since these are rare events, I don’t want to build your portfolio for outlier scenarios as they make it a lot more conservative than required. That being said we shall try to address such crisis scenarios to a certain extent by adjusting your asset allocation.

Raj: Fair enough. I think this is a sensible plan which I understand. So every 6 months we shall check the portfolio, and as long as I am within the +33% to -13% range I would be fine. In the long run, as I get to have 20 shots at these 6 month returns, eventually my returns should get closer to the long range returns.

And yes, as you told, there would be those rare crisis times when the declines might be even more than our expected range. Fair enough.

Me: Also let me show you how, your portfolio would have stuck to our bands in the last 18 year period.

As you see, except for the 2008 crash, it has never declined more than our comfort zone of -13%.

Raj:  Wow! This makes it pretty clear for me.

Me: There will obviously be several distractions say market events like budget, elections, some global event, oil price moving up or down blah blah. The key for us is to ignore the news and focus if our returns are still within our agreed comfort zone. As long as it is behaving as expected, we are good to go.

Raj: Sure. I am good to go!

Me: Once we have this part figured out, the other normal nuances of
asset allocation adjustment, comparing performance with peer group, benchmark, evaluating fund choice, what-if-things-go-wrong plan etc will be taken care by me.

Raj: Thanks a ton! This makes it clear for me.

Summing it up..

While this is obviously a hypothetical conversation, I believe this is a great way in which we can start to have conversations on the risk vs return trade off.

Here is the next step:
Figure out your 6 month comfort zone and check if your current portfolio is aligned to this.

Do take the help of your advisor or write to me at rarun86@gmail.com if you are finding any difficulty.

Let us together, nail the long term investing challenge, one short term decision at a time!

This approach is relatively new to me and I am still exploring the various angles to this. Hence it would be great if you could share your thoughts on this. Do you think this approach makes sense?

I hope to write more on this as I believe understanding risk and aligning portfolios to our risk tolerance is a crucial step to becoming a successful long term investor.

Happy investing as always!

If you loved this post, do share it with your friends and don’t forget to subscribe to the blog via Email (1 article per week) or Twitter along with the 6000+ awesome people. Look out for some fresh, super interesting investment insights delivered straight to your inbox.

You can also check out my other articles here

Disclaimer: All blog posts are my personal views and do not reflect the views of my organization. I do not provide any investment advisory service via this blog. No content on this blog should be construed to be investment advice. You should consult a qualified financial advisor prior to making any actual investment or trading decisions. All information is a point of view, and is for educational and informational use only. The author accepts no liability for any interpretation of articles or comments on this blog being used for actual investments.

You got a Large Amount to Invest? Here’s Everything You Need to Know.

10 minute read

You have been comfortably investing a part of your salary regularly through an SIP into few good equity funds. This works perfectly fine as the monthly investments average out the equity market ups and downs. Typically, going by history over the long run you would make decent returns mirroring the underlying growth of Indian businesses.

But we have another common occurrence, which unfortunately has not received much attention.

What if you suddenly receive a large amount of money?

Think bonus, property sale, inheritance, ESOP etc

A large amount is basically whatever is large enough for you. There are no hard and fast rules. I personally consider any amount more than 24 times i.e 2 years of my regular monthly savings as a large amount.

Now you have a problem.

How do you invest this in equities?

  1. Do you go all in and invest everything into equities in one shot – but what if the markets crash immediately after you invest – think Jan-2008.
  2. Keep it in cash (read as liquid funds) and invest the money when equity markets fall – but what if markets go up like crazy – think 2009, 2014, 2017
  3. Equally splitting your investments over a time frame (of around 6 months to 3 years) – this is a midway path where you try to average out your buying price. Again you will miss out if there is a sharp up move or the fall happens exactly after you are done staggering your investments. Imagine equally splitting your investment amount into 12 portions and investing for 1 year till Jan 2008.

Now while all the above are extreme examples, the take away for us is that irrespective of which strategy you use to invest your money, there will always be instances where you would have regretted not using the alternate strategy.

The only way out is to predict how the markets will move in the short run.

Unfortunately there has been no one who has been able to do this on a consistent basis.

“The idea that a bell rings to signal when investors should get into or out of the market is simply not credible. After nearly 50 years in this business, I do not know of anybody who has done it successfully and consistently. I don’t even know anybody who knows anybody who has done it successfully and consistently.” 
― 
John C. Bogle

Minimizing regret..

This means, throughout your life as you keep getting large amounts at different points in time, regret will also be a regular companion. It may either be regret of missing the upside or regret of participating in a downside.

If you think there is some secret parameter which will let you know what the markets are going to do in the short run and help you identify the perfect strategy, then the article ends here for you. I am not aware of any.

But if you are someone who agrees with me that the markets are too random and can’t be predicted in the short run, I have a solution for you.

It all starts with the humble acceptance that we cannot completely eliminate REGRET. 

Rather the only thing under our control, will be on how to minimize regret and live with it.

Let me explain with an example.

Case study

Assume you have got a large inflow of Rs 1cr. Your existing portfolio is around Rs 50 lakhs (entirely in equities).

Here is how you can go about adding this Rs 1 cr to your existing Rs 50 lakh portfolio.

First you need to answer the simple question:

What is the maximum short term loss you are willing to tolerate in your portfolio?

This will be the decline in portfolio value beyond which you might find it extremely difficult to stay with the existing portfolio. In other words, this is your freak-out point!

For the entire Rs 1.5 cr portfolio (Rs 1 cr new money + Rs 50 lakhs in existing portfolio), you understand that some bit of risk (read as short term declines) needs to be endured for better long term returns.

While it is definitely painful, you are willing to tolerate upto Rs 25 lakhs loss. Anything beyond that might be really hard on you.

To get an idea on how past declines have been, let us check the historical range of outcomes for different asset allocation between equity and debt over a 6 month period.

The workings have been calculated for the last 18 years with a large cap fund (Franklin India Bluechip Fund) representing equity allocation and a short term fund (IDFC Bond Fund – Short Term Plan) representing debt allocation.

The table can be interpreted as:

Over the next 6 months, there is a 95% probability that the returns from a 70% Equity + 30% Debt portfolio will be between -17% to 30%. This range describes the “comfortable zone” for the particular asset allocation. In other words, this is the normal behavior to be expected from the particular asset allocation.

It is hard to quantify 5% of the market, which can involve black swan events like housing bubble, dot com bust, war, earthquake etc. However you can control for 95% of the risk by choosing the appropriate asset allocation.

Why six months?

There has been elaborate research done by the US firm Riskalyze which concludes that 1 year is too long a period for investors to stay calm during a market fall while 3 months is too short. They have found that 6 months is the sweet spot where most of us want to take a decision on portfolio performance. In fact they have built an entire business around this concept. Do check them out.

Let me apply these ranges to your Rs 1.5 cr portfolio:

Since you had decided on a maximum tolerance of upto 25 lakhs loss, a 70% Equity: 30% Debt portfolio would be ideal for your risk tolerance.

This implies that going by history, it is normal to expect the portfolio to be anywhere between Rs 1.25 cr to Rs 2.06 cr in the next six months. In other words the outcome can range from Rs 25 lakhs loss to Rs 56 lakhs gain over the next 6 months.

While we have no clue where it would be in this range, but if it is in this range then everything is normal and it is behaving exactly as per expectation.

The Rs 1.5 cr will get split into 30% i.e Rs 45 lakhs in debt and the remaining 70% i.e Rs 1.05 cr in Equity.

Since there is no timing risk in low duration debt funds, immediately invest Rs 45 lakhs in your chosen debt funds. I prefer Ultra Short Term or Short Term Funds.

Rs 50 lakhs is already in equities. So we have to deploy the remaining Rs 55 lakhs in equity.

While we have addressed the 95% of expected normal outcomes via the asset allocation, we are yet to address the 5% probability of abnormal outcomes. These events though rare, will definitely happen at some point in time. Historically these events have occurred once every 8-10 years.

So how do we address these 5% probability events?

Enter the Asset Allocation Traffic Signals

While the short run is unpredictable, we can roughly approximate the long run returns. You can refer my earlier post here to evaluate where equity markets are in the current cycle. Based on the framework to estimate returns, you can classify the markets into three zones Green (very attractive), Yellow (average) and Red (very risky).

Green: Expected 5Y Returns above >15%

Yellow: Expected 5Y Returns between 8 to 15%

Red: Expected 5Y Returns less than <8%

If it is in the Green zone, then the odds are in our favor and it is better to invest the entire Rs 55 lakhs at one go. Choose 2-4 equity funds and invest immediately.

If it is in the Red zone, then the markets are extremely risky and the odds are not in our favor. We will invest in 2-4 Dynamic Asset Allocation Funds which auto adjust equity allocation based on various valuation parameters. We will shift this portion back to pure equities when the markets go back to Green zone.

If it is in the Yellow zone, then the markets are neither too risky nor very attractive. We will invest Rs 27.5 lakhs in 1 or 2 Dynamic Asset Allocation Funds and another 27.5 lakhs in 1 or 2 Equity Funds. We will shift the Rs 27.5 lakhs in Dynamic Asset Allocation portion back to pure equities when the markets go back to Green zone.

These valuation and earnings based asset allocation calls, to a certain extent help us manage the 5% abnormal market conditions.

Now for those of you who think this is a lot of work and complicated, worry not. I have a workaround for you.

What if we instead, gave the job of taking Asset allocation calls to an experienced veteran with 30 years of investing experience. Someone who has been running asset allocation strategies for the past 10 years and has a solid track record. Someone who has an experienced team tracking several parameters day in and day out and has established a good enough model which has worked so far.

What if I told you, all this comes free for you – if you can spend 5 minutes every month!

Wow!

Let me reveal the secret for you – ICICI Prudential Balanced Advantage Fund

This is an auto adjusting asset allocation based fund which moves its equity allocation between 30% to 80% based on a valuation model.

The fund is managed by Naren (read about him here). After a lot of trial and errors in the model between 2008-2010, the model in its true avatar was live and running from 2011.

The fund has had a solid track record since then and had basically pioneered the entire category. After seeing its success almost every AMC has launched its own version in recent times.

Source: ICICI Prudential AMC website

You can see that the equity allocation calls have worked well for the last 8 years. The best part is that, the asset allocation is disclosed every month in the factsheet (which gets published around 12th of every month).

If you don’t want to go through the hassles of building your own allocation model, then you can go with Naren’s model. Here is how..

Red: If equity allocation is between 30% to 40%

Yellow: if equity allocation is between 40% to 65%

Green: If equity allocation is between 65% to 80%

Thus by spending 5 minutes every month to check the equity allocation of ICICI Prudential Balanced Advantage Fund, you can make use of Naren’s asset allocation model.

Now doing all this doesn’t mean we will be able to perfectly time the market. This is basically a method to the madness, where using history and valuations as a guide we are trying to tilt the odds in our favor. The idea is to minimize regret and get reasonable participation in the upside while reducing the participation during downside.

Why do we need a framework like this?

The biggest risk whenever we get large amounts of money is INACTION.

We somehow get scared by the possibility of going wrong and keep postponing the investment decision.

So here is the deal.

Whenever you get a large amount of money, give yourself 2 weeks to decide on a strategy to invest. If you are not able to take a decision, then go ahead with the plan that I have suggested. If you think you have a better strategy, great, just execute it.

The key is to not get into the “freeze” mode!

Make this Large Amount Investing strategy a part of your annual discussion with your advisor. If you are on your own, then make sure you have the plan written down every year.

Summing it up:

When you get a large sum of money to invest, use the following steps

  1. Decide on the maximum extent of loss you are comfortable to take on your portfolio in the next 6 months
  2. Based on this, choose asset allocation split between equity and debt based on the 95% probability 6 month return range (refer the table)
  3. Immediately deploy the debt portion in short duration funds (Ultra Short Term or Short Term)
  4. Equity Portion will be deployed based on asset allocation signals:
    1. Green – Invest in 2-4 equity funds immediately
    2. Yellow – Invest in 2 Dynamic Asset Allocation Funds and 2 pure equity funds – portion in 2 Dynamic Asset Allocation funds will be moved to pure equity funds when market goes back to Green zone
    3. Red – 2-4 Dynamic Asset Allocation Funds – will be moved to pure equity funds when market goes back to Green zone

If you feel the strategy can be improved, or there are views that you don’t agree with or perspectives that can be added do let me know either via the comments or by mailing to me at rarun86@gmail.com

Happy investing as always!

If you loved this post, do share it with your friends and don’t forget to subscribe to the blog via Email (1 article per week) or Twitter along with the 5000+ awesome people. Look out for some fresh, super interesting investment insights delivered straight to your inbox.

You can also check out my other articles here

Disclaimer: All blog posts are my personal views and do not reflect the views of my organization. I do not provide any investment advisory service via this blog. No content on this blog should be construed to be investment advice. You should consult a qualified financial advisor prior to making any actual investment or trading decisions. All information is a point of view, and is for educational and informational use only. The author accepts no liability for any interpretation of articles or comments on this blog being used for actual investments.

This FISH can help you save money

Recently I have noticed a strange pattern. My impulse spends have started to increase dramatically.

Almost once, every three days, I order something from Swiggy at midnight (though I have had my dinner!). There are many things that I have bought from Amazon which I hardly use. My wardrobe is expanding perennially, thanks to no-reason sales which e-commerce companies dish out almost everyday. I have a constant itch to buy some new electronic gadget – amazon stick, one plus phone, amazon echo, wireless earphones, speakers etc.

Even if I don’t have the money, I don’t feel like postponing the purchase. The credit cards have slowly started to make me think “No worries, buy now and I will pay this off next month or put it in EMI”

If you step back and think about it, this is just the beginning.

I think “saving money” will become extremely difficult going forward led by a host of factors such as

  1. Social Media
    1. Given how easy it is to peek into our friends lives, we start comparing our lifestyle and spending habits to others via social media and end up spending money to “keep up with our peers and our increased aspirations
  2. Digital Money
    1. In a behavioral concept called “Pain of paying” though the amount is the same, it feels ‘less expensive’ and “less painful” to pay with the card or digital wallets compared to cash. More money tends to be spent due to the reduced pain of paying.
  3. Easier Loans + the new world of EMIs
    1. The credit card companies, banks, the Bajaj Finances of the world etc are all after us to provide us quick loans to buy anything ranging from cars, bikes, gadgets, clothes etc
  4. Marketers
    1. Marketing is designed to convince us that we’re deficient in some way, but that we can ‘fix’ ourselves if we purchase their product
    2. The marketers have now gone to the next level, where they have started to peep into our brains to study exactly why we buy and how to manipulate them. This emerging field is called neuro-marketing.
  5. Unbelievable convenience
    1. With the advent of delivery right at our doorsteps and one-click payments from our mobiles, its become extremely convenient for us to spend more.

If it is this difficult to save in 2018, what hope do we have for 2028?

While who we are up against is scary, we still need to put up a decent fight. And here is how I am going about with it..

My first blunder ..

When I started reading on how to solve this, the solution was simple:

Whatever can be measured, can be improved

So the initial idea was to actually track my spending so that I know where I spend. Once this is clear, I can improve on it.

Now to do it manually would be a tall ask.

Thankfully, I found an amazing app called “Walnut – Expense Tracker”. It automatically picked up my spending by reading the SMS sent by my bank.

While it worked like a charm and I diligently used it for three days, the whole process was extremely boring and I had zero motivation to do this daily.

My willpower soon gave up and I stopped using the app.

Mission failure.

If you are one amongst the elite few who are extremely disciplined and have great willpower this app will work for you. I am unfortunately a part of the “rest-of-us” category.

Learning: Any behavior which requires willpower to execute, each and every time is not a viable long term strategy

So this time, I decided that I needed a strategy which is completely automated and saves me from decision making each and every day on where to spend.

Introducing the “FISH” method of saving money..

Photo by David Clode on Unsplash

FISH simple stands for:

F – Fixed expenses every month
I – Investing for the long term
S – Short term savings
H – Happy to spend

Let me explain:

First your salary will come to your primary savings bank account. Then it will get split into the following buckets.

1) Fixed Expense:

All of us have certain fixed expenses every month, that we cannot avoid. For eg

  • House Rent
  • Electricity Bill
  • Fees
  • Gas
  • Grocery
  • Petrol
  • Internet Connection
  • Mobile Bill
  • DTH
  • Maid Salary etc

Approximately estimate the total fixed expenses. Add a 10% buffer. As there will inevitably be something which surprises you or you exceed in some categories.

This portion will continue to remain in your actual salary account.

2) Investing for the long term

This portion is for investing in your long term goals (early retirement, kid’s education etc). You can take the help of a simple online financial planner to estimate how much you will need to save.

If that sounds like too much work, a good thumb rule is to have atleast 20% of your monthly salary in Long Term Investments.

Set up an investment account in any of the platforms available and start an SIP (systematic investment plan) in few good equity funds.

You can refer here to see how I do this.

 3.Short term savings

This portion will cater to any reasonably large financial requirement (say >6 months salary) that you foresee in the next 5 years. You can take the help of a simple online financial planner to decide the amount to save every month.

Otherwise, a good thumb rule is to have atleast 10% of your monthly salary in Short Term Savings

This can be invested via an SIP in options such as

  1. Ultra Short Term or Short Term Funds
  2. Arbitrage Funds
  3. Equity Savings Funds

4. Happy to spend

The remaining amount is all yours to happily spend.

So just transfer this to your secondary bank account (open one if you don’t have) and start spending from this account.

Here is a pictorial snapshot of the entire process:

Do this segregation at the start of the month, once your salary is credited. Once you become comfortable, automate most of this process.

Since the fixed expenses cannot be completely automated, whenever you are spending on a fixed expense use the primary salary account debit card. For discretionary spends use the secondary savings account debit card

What if there is a sudden unplanned expense?

I usually maintain an emergency fund which is around 5-6 times my monthly expenses.

So if there is a short fall in my “Happy to spend” account, I will dip into my emergency fund and replace it later (mostly when I get a bonus).

And try not to use a credit card, as it defeats the whole strategy.

Why does this work?

1.Difficult to think about Opportunity Cost

Behavioral economist Dan Ariely has an interesting observation:
Money is all about opportunity cost.

In English, it means every time you order something in Swiggy for Rs 400, you are giving up Rs 400 which could be spent on something else.

In an ideal world, we should be asking ourselves all the time ‘Is this the best possible way to spend Rs 400?’

But let’s be honest. It is hard and impractical to think about each and every spending decision this way.

Instead of worrying about if we are spending right every time, the idea is to prioritize what is important to us (entrepreneurship, early retirement, kids education etc). In this method, by first allocating some part of our salary to this priority portion via long term investing and short term savings, we are eliminating the possibility of our impulse purchases affecting our important priorities in life.

2.Better Anchoring

Earlier when I used to manage money, I always saved whatever was left at the end of the month. So whenever I decide to spend, I always anchored to the entire salary amount which was sitting on my bank account. This meant for a lot of spending, I actually didn’t worry too much as the overall balance in the salary account was still large.

The moment I switched and started to first allocate to the fixed expenses, long term investing and short term savings, it let me anchor to a lesser value in the “Happy to Spend” account. So whenever I am about to spend, my reference point is not my entire salary but only 20% of my salary (or whatever is your % of salary that goes to “Happy to Spend” account).

This goes a long way in helping us make better spending decisions as the
“Happy to Spend” amount is all that we have, to spend for the entire month.

3. Lesser no of decisions

Eventually once you automate the whole process, your no of decisions are dramatically reduced.

Long Term Investments and Short Term Savings, once it is set, you don’t need to decide what to do each and every month

Further, analyzing your spends become a breeze as all you need is to check the primary savings account for fixed expenses and secondary savings account for your other spending.

No fancy apps required. Just your bank statement!

Final Thoughts

While this method is still in evolving stage, it has worked reasonably well for me in the last 6 months. Do not let the simplicity of the method undermine its usefulness.

If you are struggling to control your spending and saving, I request you to try this simple method and let me know how it works.

As always, happy investing or rather happy saving!

If you loved this post, do share it with your friends and don’t forget to subscribe to the blog via Email (1 article per week) or Twitter along with the 6000+ awesome people. Look out for some fresh, super interesting investment insights delivered straight to your inbox.

If in case you have any feedback or need any help regarding your investments or want me to write about something, feel free to get in touch at rarun86@gmail.com

You can also check out my other articles here

This strange ritual of Japanese rail workers can help us evaluate equity markets

A 15 minute read..

Japanese rail workers and their strange ritual..

A sleek Japanese bullet train glides noiselessly into the station. Then the strange ritual begins.

During the brief stop, the train conductor in the last carriage suddenly jumps out and starts talking to himself. He points at different parts of the train, station and comments something loud.

See this for yourself..

What in the world is he doing?

The Japanese call this technique, Shisa Kanko, a Japanese phrase meaning point with finger and call’. This is an error-prevention drill that Japanese railway employees have been using for more than 100 years.

The basic problem which the Japanese railways faced was that most of the accidents were caused due to human lapse of concentration and negligence rather than lack of knowledge.

Now, when you ask the rail worker to physically point at things and then name them out loud, he is forced to engage different senses via the brain, the eye, the hand, the mouth and the ears.

This makes him more conscious, aware and alert, thereby significantly reducing the possibility of unintended errors.

Studies have shown that this technique reduces human error by as much as 85 percent.

But aren’t we a lot more smarter and attentive?

Where is the gorilla?

Answer the questions in this video before you move one (it will just take 2 minutes)

As seen in the video above, all of us have our blind spots depending on where we have our focus.

Inevitably in an information overload world, the media has a significant say on where they want us to focus our attention.

As investors, this is not great for us as we get carried away by the news, focus on the wrong things and lose the actual big picture, leading to flawed decision making.

Better decision making starts with frameworks

Now all of us are sure of one thing – this is a bull market.

And yet another thing we are sure of – it will inevitably end someday in the future.

Historically we usually get to see 1 or 2 bear markets every 10 years. This means another 3-6 bear markets in the next 30 years.

In other words, we don’t get too many opportunities to learn how to handle bull market peaks and the bear markets that follow.

While we may read a lot on how to identify bull market peaks and behave during a bear market, nothing beats actually experiencing it and learning from it.

The good part is, we will have this opportunity soon (how soon is anyone’s guess). So, the key for us is to not let go of this great learning opportunity!

Now I honestly haven’t seen a full fledged bear market before. So while theoretically I should be fine, I am really not sure how I will actually handle a bear market.

What do we do about this?

I have a suggestion. Let us develop a framework to evaluate the risk in markets. Something via which we would get a sense of when we need to go slow on equities and when we should go all in into equities.

Now this does two things for us:

If it works, great! We have a framework which we all can use and have a far better investing experience.

If it doesn’t work, first blame me and later we can can always go back and check as to what went wrong and improve our framework

Instead of going blind into the final phase of a bull market, let us be prepared with a framework which can be evolved based on feedback.

Now let me be clear on one thing – the idea of the framework is not about precision – it’s just a disciplined way to get an approximate sense of which part of the market cycle are we in.

I may be wrong. But the idea is to quickly learn, improve the framework, and share the learnings so that everyone can benefit.

So let us check out the framework

Equity market evaluation framework

To evaluate equity markets I use the below 7 factors

  1. Valuations
  2. Earnings Growth
  3. Cycle – Credit Growth, Capacity Utilisation
  4. Sentiment
  5. Interest Rates
  6. Other Dynamic Asset Allocation Models
  7. Momentum

To ensure that we do not miss out on any of these factors, we shall use the “point and call” Japanese concept for each and every one of the above 7 factors.

The basic starting point will be to have a rough expectation of the long returns i.e 5-7 year returns.

Returns from equity = Change in earnings + Change in PE valuations + Dividend Yield

So basically predicting equity returns boils down to answering these two questions

  1. What can be the earnings growth?
  2. Will the valuations move up (increasing returns) or move down (reducing returns) or stay flat (not contributing to returns)

1.Valuation

For valuation I will stick to 3 metrics –

Primary metric

  • PE Ratio

 Secondary metric (will be used as a support to the primary metric)

  • PB Ratio
  • MCAP/GDP

PE Ratio:

To understand how valuations impact overall returns you can refer here.

As seen above, the Sensex is currently at a PE ratio of around 23.3 times which is well above (around 30% above) the long term average.

You can also clearly see that Sensex valuations have usually moved between high and low valuations and eventually revert back to the average.

So if we have a 5-7 year time frame and we are getting in now, our returns will improve over and above the earnings growth if the valuations at which we exit is above today’s valuation i.e above 23 times. If it is lower, then our returns will be lower than the earnings growth.

So how do we know the exit valuations?

Back to data as always

This is an interesting chart and hence let us take some time to understand.

I have plotted the maximum PE ratio of Sensex for each and every 2 year period since 2000 till 2018.

In other words this was the best valuation multiple you got, to exit over a two year period.

The interesting part is historically, you always got a chance to exit at a PE multiple of above 17!

Now while there is nothing sacrosanct about this number and the future might be different, it gives us a good starting point to think of exit multiples based on history.

It simply means, if history holds true, I have a high possibility of exiting atleast at a PE multiple 17 times (and higher than that if I have luck by my side).

So we can have a rule that states,
Post the 5th year (assuming your goal is 7 years away), you exit the moment PE multiple is above 17 times.

This implies your exit valuation multiple in the worst case will be 17 times. In the current context, from our starting multiple of 23.3 it is a drag of 37% or 6.5% per year from earnings growth.

If you assume average of 18 times as your exit multiple then it implies a absolute drag of 30% or 5% per year from earnings growth.

Pointing and Calling on PE Valuation: PE ratio implies a possible drag of 5-6% from earnings growth


Let us also check what the other metrics indicate

Price to Book Value

When you look at it from a Price to Book point of view, then the valuations look reasonable as they are close to their long term average.

But why this deviation between PE and PB?

PB = PE * Return On Equity

As seen from the above equation, the culprit for this difference in signals from PE and PB valuations is because of ROE. The ROE for Indian equities is extremely low at this juncture.

Source: MOSL

ROE usually tends to mean revert over time. We need to keep this context in mind while evaluating PE valuations which look expensive

Pointing and Calling on PB Valuation: PB ratio is reasonable. Low ROE leading to expensive PE valuation.


MCAP to GDP

Source: ICICI Pru Presentation

The current MCAP/GDP is close to historical average

Pointing and Calling on MCAP/GDP Valuation: MCAP/GDP indicates reasonable valuations


2.Earnings Growth

Anyone who has tracked analysts prediction for earnings growth in the last 5 years know one thing for sure – it is damn difficult to get it right.

So while I profess no superior powers to forecast, taking a longer time frame of say 5-7 years, provides us with a slightly better chance to project earnings growth. (Of course, this can be wrong. But hey, we need to start somewhere right!)

Just like we used mean reversion as our base case in valuations, we shall use mean reversion in Corporate Profits to GDP as our base case to project earnings growth for the next 5-7 years. A longer time frame means we are providing more time and hence a higher likelihood of mean reversion happening.

A lot of reports come up with corporate profits as a % of GDP. While different reports have different numbers, the overall number is very close to each other. I have taken CLSA’s data. (Source: Link)

The average corporate profits as a % of GDP since 2001 is 4.2%. Currently for FY19 it is expected to be 3.3%.

Now assuming mean reversion to around 3.5% to 4.5% and a nominal GDP growth of around 11% (6% real growth + 5% Inflation) we end up with a profit growth range of 12% to 18%.

Pointing and Calling on Earnings Growth: Profit Growth Expectation for the next 5 years: 12% to 18%

5 Year Equity Return Estimates

Applying these numbers to our original equation:

Returns from equity = Change in earnings + Change in PE valuations + Dividend Yield

Change in earnings = 12% to 18%

Change in PE valuations = -5%

Dividend Yield = 1% to 1.5%

Pointing and Calling on future equity return expectations: Approximate estimate of equity returns over the next 5 years: 8% to 14%.

Assuming an inflation of 5%, that is a real return of around 3% to 9% which is pretty decent!


3.Cycle – Credit Growth, Capacity Utilisation

Credit growth has started to pick up

Capacity Utilisation is increasing – early stages of a capex cycle

Source: ICICI Prudential Presentation

Pointing and Calling on Capacity Utilisation & Credit Growth: Earnings growth can receive support from: improving credit growth and capacity utilization (possibility of capex cycle picking up)


4. Sentiment

A good way to measure sentiment is use FII, DII and MF Flows into Indian equities.

FII Flows

Foreign investors have been structurally positive on India. So while there are short term instances where they took out money, they have always returned back. So whenever FII flows were negative, it was a great time to invest in Indian equities.

Now currently the FII flows for the last 12 months are negative!

Pointing and Calling on FII Flows: Negative FII flows usually indicate strong 2 year returns


DII Flows

DII flows have been very strong in the past few years which is also supporting the higher valuations. But a large chunk of the money came during 2017, which means for those investors the returns would be dismal (more dismal if it went to mid and small cap segment). So we need to monitor the DII flows very carefully.

It is currently supported by strong equity MF flows and SIP culture.

Source: Money Control

Pointing and Calling on DII Flows: Strong DII flows (primarily from MFs + SIP culture) were supporting higher equity valuations. However, early signs of fatigue visible. Needs to be monitored.


5.Interest Rate

  • Current Inflation
  • RBI Projection

Inflation is projected at 2.7-3.2 per cent in H2:2018-19 and 3.8-4.2 per cent in H1:2019-20, with risks tilted to the upside.

Source: RBI Monetary Policy date 05-Dec-2018

The good part is Inflation is expected to stay below 5% according to RBI. This implies lower interest rates.

Pointing and Calling on Interest Rates: Lower Inflation + Interest rates may lend support to equity valuations


6.Other Dynamic Asset Allocation Models

Pointing and Calling on other Asset Allocation Models: Majority of models indicate a not-so-positive stance on equities


7.Momentum & Trend

Absolute Momentum:
3M Return: 2%
6M Return: 0%
1Y Return : 6

Trend:
50 Day Moving Average : 2%
100 Day Moving Average : -1%
200 Day Moving Average : : 2%

Pointing and Calling on Momentum & Trend: Momentum & Trend is Positive


Putting it all together:

Phew. Now let us put all this together and make some sense

  • Valuations: PE ratio implies a possible drag of 5-6% from earnings growth
  • Earnings Growth: Corporate Profits to GDP well below historical average. Possible Mean reversion indicates 12-18% earnings growth environment
  • 5Y Equity Return Expectation: 8% to 14%
  • 5Y Equity Real return Expectations: 3% to 9%
  • Cycle – Credit Growth, Capacity Utilisation: Earnings growth to be supported by: improving credit growth and increasing capacity utilization (possibility of capex cycle picking up)
  • Sentiment: Negative FII Flows indicate strong returns in the next 2 years. High valuations were supported by strong DII Flows (primarily from mutual funds and new SIP culture). But early signs of fatigue in DII flows – needs to be monitored
  • Interest Rates: Lower Inflation + Interest rates may lend support to equity valuations
  • Other Dynamic Asset Allocation Models: All models indicate a not-so-positive stance on equities (due to higher valuations)
  • Momentum & Trend: Both are positive

We can classify markets into 4 cycles: Bust, Best, Boom, Bubble (borrowed from this interview of ICICI Prudential Sankaran Naren’s framework here)

All these indicators put together, indicate that we are not in a bubble zone. The valuations indicate that we are neither in the Best zone. While mid and small caps have seen a partial bust, overall the markets in my opinion are still in the Boom zone as the earnings growth is yet to pick up and the start of earnings growth might lead to decent returns.

So for those who are investing now different combinations of Multicap funds and Dynamic Asset Allocation funds can be a good option to build portfolios.

Given the early signs of fatigue in DII flows, I am still a little worried on going for mid and small caps directly and rather would play them through multicap funds.

This is an evolving framework and I hope to update it every 6 months. Remember I can be wrong (most often I will be). The whole idea about documenting and sharing the framework is to create discipline, to stay humble and to take feedback both from you and markets to improve this framework.

If you feel there can be areas that can be improved, views that you don’t agree with or factors that can be added do let me know either via the comments or by mailing me at rarun86@gmail.com.

Happy investing as always!

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If in case you have any feedback or need any help regarding your investments or want me to write about something, feel free to get in touch at rarun86@gmail.com

You can also check out my other articles here

Disclaimer: All blog posts are my personal views and do not reflect the views of my organization. I do not provide any investment advisory service via this blog. No content on this blog should be construed to be investment advice. You should consult a qualified financial advisor prior to making any actual investment or trading decisions. All information is a point of view, and is for educational and informational use only. The author accepts no liability for any interpretation of articles or comments on this blog being used for actual investments.

Investing Chitra Katha: How to invest money in your 30s

This is my investing strategy..

1.Faith in equities


The real equity return was positive in every country, typically at a level of 3% to 6% per year. Equities were the best-performing asset class everywhere.

The Indian version of the same book..

2. Your faith will be regularly tested..

3.Discipline to invest regularly

Jadav created an entire forest single handedly, spreading across 1,360 acres.
The forest contains several thousand varieties of trees and has attracted elephants, rhinos, deer, wild boars, reptiles, vultures, and Royal Bengal tigers. 

A simple monthly investment in equities done consistently through market ups and downs over a long period can create a similar magic!

4.Patience

5.The power of compounding

6.Focus on 2-4 good funds

7.Choose experienced fund managers

8.Lower Costs – Choose Direct plans

9. Initial 10-15 years, financial capital is a small portion relative to future human capital => Focus on saving more and maximizing equity allocation

Asset Allocation, Market timing etc can wait till your financial capital reaches a reasonable size relative to human capital!

10.Automate the whole process

You can track the progress of the above strategy here

If you loved this post, do share it with your friends and don’t forget to subscribe to the blog via Email (1 weekly newsletter) or Twitter along with the 5000+ awesome people. Look out for some fresh, super interesting investment insights delivered straight to your inbox.

If in case you have any feedback or need any help regarding your investments or want me to write about something, feel free to get in touch at rarun86@gmail.com

You can also check out my other articles here

Disclaimer: All blog posts are my personal views and do not reflect the views of my organization. I do not provide any investment advisory service via this blog. No content on this blog should be construed to be investment advice. You should consult a qualified financial advisor prior to making any actual investment or trading decisions. All information is a point of view, and is for educational and informational use only. The author accepts no liability for any interpretation of articles or comments on this blog being used for actual investments.