“What-if-things-go-wrong” Plan

10 minute read

Nowadays, everyone is a long term equity investor..

Recently I had a conversation with one of my friend, who wanted my views on his equity mutual fund portfolio and the market.

“While I have no clue on what will happen to the markets going forward, expecting the last 3-5 year returns to repeat will definitely be a tall ask. The expectations need to be toned down and we need to brace ourselves for intermittent declines” went the conservative me.

“No worries. I can handle the falls, I am a long term investor and my horizon is 15 years!!”

Here is an additional data – He has started investing in equities only recently and is yet to experience any serious market decline.

Now honestly, it would be awesome if he really turns out to be a long term investor. But my worry is what if he is underestimating the actual emotional stress that he will have to undergo during a equity market correction.

My bigger worry is the fact that there are thousands of new investors entering the equity markets day by day, with heightened expectations and misplaced confidence on their ability to handle the market declines.

Am I being overly pessimistic here?

A honest confession…

Despite being a part of a large experienced firm with access to a support system in the form of brainy colleagues, market veterans, fund managers, name-it-and-I get-it data access and sophisticated software tools, we ourselves have our moments of panic, self doubt and fair share of mistakes. I know one thing for sure – handling a falling market is a lot tougher than we think. And even the best of investors have had their share of mistakes during a falling market.

Now why am I talking about a bear market now?

“The macro is improving, earnings are set to pick up, domestic flows are strong, interest rates are low, real estate and gold are not doing well, blah blah ..we are in the mother of all bull markets” goes the narrative.

I don’t have a view on the above but instead have a simple rule which I follow..

“When everyone is focused on the returns, focus on the risk and when everyone is focused on the risk, focus on returns”

So while, I profess no predicting capabilities or ability to time the market, inevitably good times in markets have always been followed by bad times.

Now that things are going great for the market, we are relaxed and have a clear mind, why don’t we spend some time thinking about a plan on how to handle things if at all something goes wrong.

And just in case something goes wrong, we have a plan and are slightly better prepared. Otherwise if the bull market continues, then it’s happy times as usual 🙂

Sounds fair?

So here we go..

Assuming things will go bad someday in the future, we need to answer two questions..

  1. Why is it so difficult to handle a bear market?
  2. How do we prepare ourselves for a bear market?


The heat of the moment effect

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The popular behavioral scientist Dan Ariely and his colleague George Lowenstein in 2006 came up with a weird yet very interesting experiment. Let us listen to what they actually did.

This tendency for us to behave differently when in a calm state of mind (cold state) and differently when in the heat of the moment (hot state) is what behavioral scientists call as “empathy gap” or “heat of the moment” effect.

Now while most of wouldn’t have heard of this technical term “empathy gap”, but we can easily relate to the fact that when we’re emotionally upset, angry, happy or aroused, we don’t always make the best decisions.

The key takeaway for us is this:

When we are calm and comfortable, we turn out to be extremely bad in imagining how we will act during times of emotional strain (think fear, anger, hunger, exhaustion, thirst etc).

Such an under-appreciation of how we behave during times of emotional strain is where the trouble actually starts.

Now before we move ahead, spend some two minutes and answer this question

How do you think you will behave if the market cracks by 25%?

But remember, this is you in your “cool & calm” avatar!

Your “emotionally charged” avatar might have different plans.. and if you are like the rest of us it will panic and freeze!

Now that you are self aware, that is one step in the right direction.

But the problem of our “emotionally charged” avatar panicking and giving up on our equity investments still remains.

What do we do?


Odysseus to the rescue

In the legendary greek mythology, The Odyssey, the hero Odysseus takes on several challenges throughout his travels and at one point, he and his men are required to sail past an island that is inhabited by Sirens. The Sirens were beautiful but dangerous mermaids who lured sailors with their enchanting music and beauty. Under the spell of these Sirens, the men would hopelessly sail their ships towards the island of the Sirens, crash their boats on the shores and die.

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Knowing this cruel fate of men who came before him, Odysseus though a man of great strength, not trusting his ability to resist temptation, decided to plan much ahead.

He instructed his men to plug their ears with wax so that they wouldn’t be able to hear the Siren’s song. He also asked his men to men to tie him to the mast of his ship so that he wouldn’t be lured to steer the ship towards the Sirens.

This method of previously committing towards an action while in a normal state is called pre-commitment.

The bear market is the Siren in our case. While we don’t know when, we must always be prepared for the Siren.

We have to protect ourselves from “ourselves” whenever the bear market arrives.

As Odysseus recognized that he would become a different person when subjected to temptation, we must recognize the same in ourselves when subject to a bear market.

All this points to a simple strategy –

We need to have a battle plan and pre-commit to it!


The Battle Plan

The last thing you want to do in a falling market is to be forced to sell equities to fund a near term requirement.

So let us solve this problem first

1.Emergency Fund

  • Build your 3-6 month spending needs in a liquid fund
  • With all talks about pay cuts, job losses etc during a bear market, this becomes a welcome relief

2.Fund your short term requirements (next 5 years)

  • Build using a short term debt mutual fund or arbitrage fund – you can invest the entire amount if you have or start an SIP

Now with near term money requirements out of our way, we are left with our long term investments and the most important thing from hereon will be our ability to remain calm and hang on.

3.Pre-commitment plan

Write down what would you do when the

  • Market falls 10%?
  • Market falls to 20%?
  • Market falls to 30%?
  • Market falls to 40%?
  • Market falls to 50%?

Take some time out and really think this through.

When the market goes down by 10%, what would you do?

Would you increase your equity allocation? Do you have cash which you can deploy? Should you wait for further correction? Have you identified where to invest? Should you sell some equity? If you sell, when will you get back? What are the parameters you plan to check? etc

Similarly start thinking about your decisions to be made at 20% fall, 30% fall, 40% fall and 50% fall.

The key thing to remember:

This plan is never going to be a one-size fits all plan. Each and everyone of us based on which stage of life we are, our overall portfolio size, understanding of equity markets and our ability to take risks will have a different plan.

So build a customized one for yourself.

Here is the most important part – put it in writing and whenever the situation arises and you have to make a decision, refer to this and get a sense of what your “cool & calm” avatar wanted you to do.

Also discuss with your better half and make sure both of you are convinced of the plan.

Hopefully, we should be able to steer clear of the lure of the siren!

4.Set the right frame

If you have just started saving, then approximate the expected 15 year value of your SIP. Then find the current % of your equity portfolio vis-a-vis your overall future portfolio. If it is a small proportion then don’t be too worried at this juncture. Even if there is a fall, the bulk of your portfolio is yet to be built, and what better period than a bear market to build your portfolio.

If the amount is large (say >5x your salary), then follow asset allocation, and decide on how you will increment equity allocation at various falls (the pre-commitment plan).

5.Stop listening to experts

  • Remember the “authority bias” – i.e in times of decision making during uncertainty we always turn towards the experts and they will have a substantial influence on our decisions
  • The truth will always be this – “No one really knows”
  • So stop listening to doomsday theories and continue with your pre-committed plan

6.Instruct your financial advisor (if you have one) to monitor you to act as per the committed plan

Most of us think a financial advisors job is to recommend investment products and ideas. But I believe, even a half decent investment website or a blog can help you out in that. The true value add of a good advisor however is actually on the behavioral front. During bad times there is nothing which can replace the support and comfort that a fellow human advisor can provide.

Anyway, in case you have a good advisor, work with him on the pre-commitment plan, take a printout with your sign on it and tell him it’s his responsibility to make sure you execute as per plan.

There you go..Your battle plan is ready 🙂

Parting thoughts..

But wait, hang on..

What if after all this we still panic and fail in executing our pre-committed plan.

Truth be told. That’s a pretty bad thing to do. But nevertheless, some of us may still succumb.

In that case, we need to go back to our battle plan sheet and update on what really happened vs what you had planned. This will serve as a mirror for our true risk profile rather than those theoretical questionnaires which are usually used to access our risk profile. This will also be our self introspection moment in understanding us as investors.

Based on this, in the future, we need to adjust ourselves to a much more realistic equity allocation going forward.

Remember, investing is a lifelong activity.

The idea is always to keep improving and becoming a much better investor version of ourself with the passage of time.

And yes, never let a crisis go waste.

So while we wait for the next one,  get your battle plan ready and as always happy investing 🙂

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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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5 blind men and the equity markets

One of the best pieces of advice that I received from my boss goes like this –

“Arun, there are two periods which will define you and your career…

How you behave during times of success and

How you behave during times of failure.

The other things mostly will get taken care of..”

On similar lines, I believe being a good investor is all about two things –

How we behave during the best of times (bull markets) and the worst of times (bear markets) will eventually define us as investors

In other words, this means we need to be able to evaluate the degree of risk in equity markets at various points in time so that we can manage our behavior correspondingly.

Unfortunately, there are several moving parts in evaluating equity markets and for a large part of my investment career I have been guilty of taking only one perspective (based on whichever was the popular narrative at that point in time) and missing out on the bigger picture.

Image result for the blind man and the elephant

This was exactly how I was evaluating equity markets!

Anyway, better late than never..

While I proclaim no sudden  “enlightenment” on what drives the market, the attempt here is to share with you a slightly more holistic framework on evaluating equity markets.

I believe, there are 5 perspectives or vantage points, that we need to take while evaluating the equity markets.

are Organics

Since this is an evolving topic, I shall update corresponding articles underneath these topics as and when I write.

1.Valuations

Focus will be on various valuation parameters to evaluate on how expensive or cheap the equity markets are..

What returns will I get from equities going forward?

What returns will I get from equities going forward? – Part 2

A layman’s guide to equity valuations

2.Earnings Growth

We will track the fundamental long term driver of equities i.e earnings growth in this section. We will also see various methods to evaluate earnings growth.

What returns will I get from equities going forward? – Part 3

Equities – dismantling the returns !!

Equity Investing – Just 2 things to remember

3.Demand and Supply

This vantage point is based on the The Law of Supply and Demand.

It simply states that when demand for a freely traded commodity exceeds the supply of that commodity, its price will rise and vice versa. And, since common stocks are a freely traded commodity, their price movements are dictated by the Law of Supply and Demand.

In this section, we will be analysing FII flows, DII Flows, MF Flows, IPO issuances, market breadth indicators, other asset class returns such as real estate, fixed deposits, gold etc

4.Interest rate

Interest rates act like gravity on asset values – The higher the rate, the greater the downward pull. That’s because the rates of return that investors need from any kind of investment are directly tied to the risk-free rate that they can earn from government securities. So if the government rate rises, the prices of all other investments must adjust downward, to a level that brings their expected rates of return into line.” – Warren Buffett

In this section we will evaluate our outlook on domestic interest rates..

5.Global Markets

To get an approximate sense of global markets via global market commentaries from popular investors, valuation parameters etc

 

Book mark this post, and hopefully a few years down the line as we put the pieces of this jigsaw puzzle together we should have a much better understanding of the equity markets.

As always let us keep learning and sharing.

Happy investing folks and don’t forget to subscribe to the blog:)


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

 

 

 

 

 

 

Long term SIP is not risk free, yet you can workaround it

10 minute read

In recent times, there has been a significant interest in equity markets thanks to the strong returns of the last few years. The best thing to have happened is the new culture of SIP (systematic investment plan).

INDIAN MUTUAL FUND INDUSTRY'S AVG.ASSETS UNDER MANAGEMENT (AAUM)

Source:AMFI, Link

A SIP is a simple investing process, where you invest a particular amount each and every month regularly. This is extremely convenient as the SIP amounts are automatically debited every month and also coincides with our cash flows (monthly salary). The SIP also supposedly solves the major issue of trying to time the equity markets as the investments are equally spread out and hence average out the ups and downs in the equity market.

Be present and mindful when purchasing new items. Ask yourself: do I need this? If I want this, do I have a place to store it? Do I own many of the same already?

All this is good.

But going by the numbers above it looks like a lot of us are entering the equity markets for the first time and SIPs seem to be the preferred route for many.

Given the great returns of recent times, there is a possibility of misplaced expectation if SIPs are not understood or sold properly.

Hence before you jump in, it is extremely important to understand some of the underlying nuances in the SIP concept (which are not generally talked about) so that you end up with a good experience and most importantly decent returns over the long run.

Expectation: I will continue my SIP for 10 years in a few equity funds. Life is taken care!

Here is an interesting article, which explores this question – Link

This is the long term 10Y SIP returns for Sensex over different periods as per the article.

Long term SIP does not remove risk and other important lessons from historical equity returns

And yes, here is the shocker –

There are periods when the Sensex 10Y SIP returns have been negative!

How is that possible?

  • Doesn’t an SIP stagger my investments thereby saving me from volatility?
  • Isn’t 10 years a reasonably long horizon for equities?

Now before you panic and redeem your SIPs, let us explore this further..


Never forget the underlying equity portfolio

Let us start with an hypothetical example. Assume I invest, Rs 10,000 every month for the next 10 years in a few equity funds and my returns are 15% annualized. This is how my portfolio would have grown.

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I end up with around 27.5 lakhs at the end of 10 years.

But what is the blue and green component?

The good part 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.

The green bar represents 1.2 lakh invested via SIP (Rs 10,000*12 months) into our portfolio every year. The blue bar is our overall portfolio which grows in size.

Now the key is to realize that as time progresses, the incremental amount which gets invested via an SIP over a year becomes small compared to the overall portfolio (Sample this – In the above example, the incremental SIP component after the 6th year contributes less than 10% to the existing portfolio).

And hence, while the incremental amount is staggered across 12 months, the existing portfolio is completely exposed to equity markets. 

Thus the larger portion of the portfolio will be susceptible to equity market ups and downs in the later years and SIP will have little impact in reducing overall volatility.

Now armed with this simple insight, let us get back to solving the problem of 10Y SIP returns in equities sometimes being low.

Key Insight: The equity market returns in the last 3 years become very critical in a 10Y SIP calculation as almost 50% of the final portfolio value gets created in the last 3 years.

Progression.png

Going by this logic, the periods of low 10Y SIP returns should mostly be the ones where the last 3 year equity returns were dismal.

But nothing like concrete data. So let us check our thesis with actual evidence..

Given below are the SIP returns for different holding periods (7Y to 20Y) in Sensex across different starting dates starting from 1980 till date covering almost 28 years.

SIP Returns.png

The SIP returns below 10% has been shaded in red, 10% to 12% in yellow and above 12% in green.

Now if you are like the rest of us, you must have switched off seeing the complex table above. No worries, just relax, take a deep breath and focus only on the 10Y column. Take a note of all the periods where the returns were lower than 10Y (i.e the ones shaded in red)

You would have noticed that, 10Y SIP returns have been low for investors who started their SIP between mid of 1990 to 1994.  Going by our last 3 years being bad logic, most of the returns between 1997 to 2004 must have been really bad for Sensex.

Let us check..

CY Returns.png

As expected, the returns of Sensex has been poor between 1995 to 2002 – which has led to weak performance in the 10Y SIPs started between 1990 to 1994.

What does this mean for us?

For all those who have started or are planning to start their SIPs now – the Sensex returns of 2025-27 will be the critical determinant of overall returns (the previous 7 years of course do matter but of slightly lower significance).

So at this juncture, don’t break your head over near term concerns of whether the market is expensive or not today as your overall portfolio has not yet been built and your incremental money via an SIP will get averaged out over the ups and downs of equity market..

But what if we end up as the unlucky lot and the returns of 2025-27 goes for a toss?

Unfortunately, we have no way of predicting what will happen to the markets after 7 years.

But, all is not lost..there are a some investors who have actually experienced this situation earlier..Maybe we might find some clues there..

Let us go back and find out what happened to to the unlucky 1990-94 SIP investors.

Unlucky SIP Investors

Now with the benefit of hindsight, what would have been your advice to them?

Let me guess your magic words..

“Boss..Hang on for a few more years”

I know it sounds outrageously simple and dumb. But truth be told it is, perhaps emotionally the most difficult to pull off.

As seen above, the unlucky investors by simply extending their time frame to around 11-15 years, could have reversed their fortunes!

Takeaway: When doing a long term SIP in equities a time frame of 10-15 years is required for reasonable returns (and always be prepared to extend your time frame)

Even if you manage anything above 10% in Sensex, funds managed by good fund managers should be able to provide an outperformance of around 2-4% which implies a 12-14% return which is good enough.

Any other solution?

The other way especially for large portfolios, is to practice asset allocation (i.e allocate between equity, debt and gold and re-balance based on market conditions. This is easier said than done. But no worries I will address them someday in the future.)

Summing it up

  1. SIP will take advantage of equity market ups and downs only in the initial years, when the underlying equity portfolio is just about getting built
  2. As years progress, the underlying portfolio in most cases will grow and will be subject to equity market ups and downs
  3. Even 10Y SIPs can have lower returns as equity market returns in the last 3-4 years have a large bearing on overall returns
  4. Simple solution is to be prepared to extend your investment time horizon (to around 11-15 years)
  5. For large portfolios, asset allocation while behaviorally difficult to implement is a great solution (if you have a good advisor to help you out)