Market Crash: How could we have reduced the pain?

The last few weeks have been terrible for equity investors. And we don’t know if it will get worse.

The market correction has been savage. And nothing has been spared. The best of blue chips have been battered. So have mid and small caps. Global equities have been trashed too.

It is not just the quantum of correction but also the pace of it, that has most investors worried.

I do not want to sound preachy. This has been a learning experience for me too. I was investing in equities at the time of global financial crisis too. However, I was preparing for b-school exams at the time. The priorities were different. The portfolio was smaller. Therefore, the market fall did not really affect me. Now, things are different. I have to look after not just my portfolio but the portfolios of my clients too.  Therefore, there is a lot of pressure this time. At the same time, there is one thing that has helped me and my investors handle this sharp cut better. Thought I should share. It is no rocket science but plain vanilla asset allocation.

What could have helped?

Sticking to a prudent asset allocation would have reduced the pain. If you believe your long portfolios should have 100% equity, this is a rude awakening for you.

I prefer not more than 60% equity exposure even for long term portfolios. The equity exposure includes both domestic and international equities. If you are a conservative investor, you can reduce allocation to say 50% equities or 40% equities or even lower. The key lies in the upper cap on exposure to a particular asset class. No asset class or investment strategy works all the time. That’s where diversification helps. And a prudent asset allocation approach can provide this much-needed diversification.

And then, you rebalance your portfolio to the target asset allocation at regular intervals. As I discussed in an earlier post on portfolio rebalancing, regular portfolio rebalancing can provide you higher returns (than either of the underlying assets) at lower volatility.

Let’s say there are only two asset classes, equity and debt (fixed income). For the long term portfolio, you decide to work with a 50:50 (equity:debt) asset allocation. If you have Rs 10 lacs to invest, you invest Rs 5 lacs each in equity and debt. Over the next year, the equity portfolio does remarkably well and grows to say Rs 7 lacs. The debt portfolio grows to only Rs 5.5 lacs. Total portfolio value= Rs 12.5 lacs. At the end of the year, you rebalance to your target asset allocation of 50:50. You sell Rs 75,000 of equity and shift it to debt. If the reverse had happened and equity portfolio had crashed 20%, you would have to shift Rs. 75,000 from debt portfolio to equity. With this simple approach, you are buying low and selling high.

If tax rules prevent you from shifting money, you can tweak your incremental investment allocation to reach your target allocation.

There is no requirement to rebalance your portfolio on a daily or weekly basis. Capital markets tend to have momentum and hence rebalancing too frequently can be counterproductive. Annual rebalancing frequency sounds good to me. You can also rebalance if the allocation moves beyond a certain band. Let’s say (continuing with the above example) you decide that you wouldn’t rebalance until the allocation to equity or debt breaches 55% or 60%. Once the threshold is hit, you rebalance. You can use any rebalancing frequency or method. The idea is to not let it slip too far away from your target allocation and comfort zone.

During global crises, the correlation between domestic and international equities can be high. Therefore, you might get the impression that international equities do not provide any diversification. However, you can expect correlation to be lower over the long term.

In the present context, if the Nifty/Sensex corrects 30%, your equity portfolio will fall in that range. However, from the overall portfolio perspective, you are down only 15%.

An asset allocation approach will appear very conservative (make you uncomfortable) when the markets are going full steam. However, it is during bad times like these that you realize the benefits of asset allocation.

If you are young, this is a great learning experience.

If you are a retiree or about to retire, I hope you had planned well, and you don’t have to withdraw from beaten-down stocks and mutual fund investments. This is an example of the sequence of returns risk.

There is another school of thought that asks you to reduce equity exposure when certain technical levels are breached. I am talking about tactical asset allocation. For instance, if the Nifty breaks 200-day moving average, then you reduce your equity allocation (and increase equity exposure when it is the other way round).  In this current scenario, this would have worked exceedingly (at least so it seems) well since you would have reduced equity allocation around 10,500 Nifty levels. However, that would have required you to sell at a loss and not many have such mental fortitude. There can be whipsaws which Moreover, this runs counter to the value approach of investing. Remember nothing works all the time. The asset allocation approach is much simpler to execute.

What do you do NOW about lower market levels?

Don’t rush to invest.

Don’t speculate.

Don’t dive headlong.

Do not borrow to invest.

Invest in a staggered fashion (assume your asset allocation permits).

When the markets fall, there is a natural tendency to invest money at lower levels, especially if you are a Warren Buffet fan. After all, the same stock you have been following for a long time is much cheaper than it was a few days or weeks back. However, you need to resist such urges. The stock may correct even further. Therefore, a pragmatic choice will be to stagger your purchases.

It may happen the stock/market may bounce from here and you may not see such levels again. A missed opportunity. Yes, that’s possible and so be it.  For most, long term wealth creation is only possible through a process and not through long-shot investment calls.

Write down your investment plan i.e. how much you will invest (amount/percentage levels). Or it could be any other plan (weekly/monthly investments). Stick with it. Don’t let your emotions play games with your mind.  Nobody has infinite amounts of capital to deploy at lower levels. If you run out of capital even though the markets show no sign of bottoming out, so be it. Your monthly investments will keep getting advantage of lower levels. Stick to the plan. While preparing the plan, always keep an eye on asset allocation.

Don’t get carried away by what you read on social media or watch on television. There will be all kinds of forecasters. Nobody knows what happens in the short term. There are people who know that they don’t know. And there are people who don’t know that they don’t know. Stick with your investment plan.

I read on social media where a user advised to borrow against your house to invest in equity markets since the valuations are very attractive. A stupid and irresponsible suggestion. Even if the said user is right about valuations, this is no guarantee to investment success. As famous British economist John Maynard Keynes put it, “Markets can stay irrational longer you can stay solvent”.

Disclosure

My portfolio and the portfolios of my investors have taken significant hits. However, the asset allocation provided some comfort. Fortunately, I was not very comfortable with the valuations for some time. Hence, in most portfolios, the equity allocation did not breach 50% of the overall portfolio. Lower allocation to equities was lower for various other reasons too. Having said that, I did not expect the correction to be so swift and sharp. In fact, I asked at least a few clients to move some money to equities at a much earlier stage in this correction (around 10,500-11,000 levels). I rushed. In hindsight, I could have waited a bit more. That’s how markets work. If we could forecast the exact trajectory of market movements, the equity investments won’t be risky and the return premium would vanish. At the same time, a conservative asset allocation prior to this correction gives us enough room to shift money from debt to equity at current lower levels. These past 15-20 days have been a learning experience.