If you are new to equity markets, you may have some discomfort with volatility. If you are closer to retirement or you are making a lumpsum investment, this discomfort is quite justified too. You can lose a lot of money and put your financial well-being in danger.
However, if you are a young investor, volatility should not concern you too much. Let’s try to understand why.
Let’s say you land up your first job at the age of 23 and you can invest Rs 5,000 per month. Every year, you can increase the amount by 5% every month. By the way, Rs 5,000 from your first salary may not be as easy since many non-discretionary expenses may not leave you with much. Let’s assume you earn a constant return of 8% on your portfolio.
What does this table show?
When you are a new investor, bulk of the increase in portfolio size is due to fresh investments. The returns on your portfolio do not add significantly to your portfolio. As you move closer to the retirement, your portfolio becomes bigger and fresh investments are only a small portion. At such times, you need to take greater care of accumulated wealth.
It shows that you can start small and still accumulate great wealth (at least in nominal terms) if you stick with the investment discipline.
What about volatility? After all, the concern that we are trying to address is volatility. Equity returns are volatile and it is not fair to expect equity markets to deliver 8% year after year.
Let’s now look at that.
As you can see from the table, a major portion of the increase in the portfolio size comes from the fresh investments that you make during the year. If you were to have a down year, these percentages will only grow. As a young investor in the accumulation phase, you shouldn’t worry much about volatility or even bear markets (easier said than done). Volatility can be your friend during accumulation phase.
Rather than getting scared if the markets don’t do well in your initial years of investments, you should be happy that you are getting to accumulate units (ownership) at a lower price. When the good times come, you will get greater bang for the buck since you accumulate units or shares at a lower price.
Let’s look at an alternate sequence of returns. You have 38 years of working life in the example discussed above.
You earn -5% p.a. for the first years. Then you earn 22.78% for the next 5. This goes on for the first 30 years. For the last 8 years, you earn a return of 8%. With this sequence of returns, the CAGR is 8% p.a. (as discussed in the previous example).
With this sequence of returns, you will retire with a portfolio of Rs 3.45 crores. In the constant return (no volatility) example, we have ended with Rs 2.55 crores.
I concede I have chosen the sequence of returns to suit my argument. With a different sequence, the returns can be completely different. However, my intent is to show that even when you start with a bad sequence of returns, you can end up with a higher corpus. In fact, it is these bad returns that result in a bigger corpus. The premise is that long term CAGR is intact at 8%.
You can end up with a bigger corpus even with a lower CAGR
Let’s now work with a lower CAGR of 7%. You earn -5% p.a. for the first years. Then you earn 20.52% for the next 5. This goes on for the first 30 years. For the last 8 years, you earn a return of 7%. With this sequence of returns, the CAGR is 7% p.a. (as discussed in the previous example).
In this case, you retire with Rs 2.73 crores (higher than Rs 2.55 crores with constant returns of 8% p.a.).
Again, this shows how volatility has helped you.
There are behavioural aspects to worry about too.
For a small portfolio size, the absolute impact of good or bad returns is also small. For instance, the difference between year end balance for -10% p.a. and +10% p.a. on Rs 1 lac portfolio is only Rs 20,000. It is Rs 20 lacs for a Rs 1 crore portfolio.
Moreover, if you are investing Rs 60,000 per annum, you will still end up the year with Rs 1.5 lacs (with the added benefit of accumulating units at a lower price). However, the same Rs 60,000 is change for Rs 1 crore portfolio. You will still end the year in red at Rs 90.4 lacs. Your portfolio can go up or down by more than Rs 60,000 (your annual investment) in a day.
Poor returns from volatile assets (say equity) can be damaging when you are about to retire or in early years of your retirement. To put it another way, poor returns can cause a very big problem when you are about to enter decumulation phase or have entered decumulation phase (drawing from your portfolio to meet expenses). By the way, poor returns are damaging during any part of retirement but the damage is much bigger if your portfolio sees big drawdowns during early part of retirement. I have covered this aspect in detail in this post.
If you are a new investor, what should you do?
For your short-term goals and emergencies, keep money in fixed deposits or debt mutual funds.
Work with an asset allocation approach for long term goals such as retirement. While there are many suggestions about the right asset allocation for you, a 50:50 equity:debt allocation sounds like a very healthy compromise. For now, I am not getting into gold, real estate or foreign equities as part of asset allocation.
Asset allocation approach is also important because you are not sure of your risk tolerance to begin with. My experience suggests that everybody is extremely risk tolerant during bull markets. Most investors don’t figure their real tolerance out until they go through a severe market downturn. Heavy portfolio losses in the initial years can scar you and keep you away from equities for a long period. This won’t be good and you won’t be able to able to get the benefit of rupee cost averaging during the accumulation phase.
Rebalance at regular intervals. Again, the “right interval” is tricky to arrive at. Think you can give yourself a long rope. Keep tax aspects and exit penalties in mind while rebalancing.
Focus on earning more. Your time is better utilized acquiring new skills than figuring out the best mutual fund for you. Better skills can help you earn more and increase your potential to invest. Finding the best mutual fund is a never-ending exercise since the baton keeps on passing. Moreover, since your investment portfolio is small at this stage, your energy is better spent elsewhere.
To keep things simple, pick up an index fund or an ETF and start investing regularly (through SIP or otherwise). If you prefer active managed, pick up no more than 2 actively managed equity funds.
Keep your head down and keep investing. Do not worry about volatility and severe downturn. Just keep investing every month. Remember, during accumulation phase, volatility can be your friend. You just have to get comfortable with it.