Preparing for the next crisis

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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Author: Arun

Hey! I'm Arun and I work for the research team of a boutique wealth management firm based out of Chennai. The idea behind this space is to share my learnings/mistakes and hopefully help people in making better investment decisions :)

3 thoughts on “Preparing for the next crisis”

  1. Great article Arun. This one is truly for me as I am a beginner in market. Pre-commitment plan is very interesting. Would be great if you can share your experience on a bear market or during a market correction like what can be done or what not to be done. Though it’s our call to make decisions, at least we can follow if we got an idea/thought on it. I have bookmarked this article as I need to re-read again and again to understand/get prepared for the emotional stress that is yet to come.

    Thanks again for sharing your thoughts on this!

    Thanks,
    Ram

    Like

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