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.

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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.