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.

Advertisements

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.