Last Updated on February 12, 2022 at 6:14 pm
Imagine this scenario: the stock market falls by about 50% – not suddenly over a few days but over months and months, say over three years. Since there is no sudden fall, there is no sudden recovery either. The market stays underwater (below the previous all-time high) for the next five years. Can you manage this situation financially? The question has nothing to do with managing emotions; we will know this only if/when it happens. Can your net worth, your income, your expenses handle this situation?
As you read the scenario, if you thought:
- “Is this possible?”, the answer is, most definitely!
- “I will just invest more!” It is not as easy as that. A fall is an opportunity only if the recovery is fast. If it takes years, the risk increases with time lost.
- “surely the govt will step in and do something?”, I am not discussing if the govt would manage (their interests). I am asking “can we manage?”. Very different questions!
- If you are part of the “this is volatility, not risk” club or
- if you thought, “ok, so this is possible, but the probability is extremely low, is it not?” meaning you reject this as unlikely, then we should part ways right here.
- “Are you talking about a Japan-like equity market?” not exactly. A few years of the market trading below its all-time high is quite common!
If you asked, “what is the point?” then I hope this exercise will provide some perspective on whether our investments rely on hope or an actual plan with a fail-safe in place. Perhaps when the market actually falls by 50% and recovery takes forever, we might remember this exercise.
Before we begin, let us appreciate that the situation mentioned above can take an emotional toll on even the most experienced investor because it does not happen every day. How we would react is, at best, unknown; at worse, we are likely to panic (perhaps justifiably!).
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We could ignore all the logic presented below if emotions rule our decisions. If we do not think of (and record) logical scenarios when the market is ‘up’, we eliminate even the little chance of reminding ourselves of it when the market is ‘down’.
The primary question to answer is, “will I still have a job?” “will I still have an income source?” This is the immediate need. For many people, the answer would be no. How will I put food on the table? An emergency fund will not help – it is for a one-off use, not regular withdrawals. This is when all that talk and reading about “multiple sources of income” becomes most relevant!
Can I handle a 50% drop in equity plus years plus years lost in recovery? Emotionally I do not know, never been there; never done that. Financially, at the very least possible. If today my equity holdings reduced 50% in value, my financial independence status would drop from 50X to 32X (X = current annual expenses). I have assumed a 20% drop in my NPS corpus (this has 15% equity and gilts). My current asset allocation is about 60-63% equity, and the rest in debt (most of this in NPS).
If I was not retired (from gainful employment), I might let it ride and wait for recovery (remember we are wearing a theoretical logical hat, how I would react, no one knows).
If I were retired, I would scramble to change my asset allocation, fortify my income, reduce expenses, etc. This is the reason why the robo advisory template plans for guaranteed income for the first 15Y years in retirement, with the rest of the corpus managed in three buckets of low, medium and high risk.
Notice the importance of luck in all this. I imagine a 50% drop in equity from a 50X (total) corpus. This means that for the 12+ years that the corpus has been accumulating, it is sheer luck that a 50% drop did not occur (although I saw no returns for the first five years and at least two 20% plus drawdown events)
What would I have done if I had only 5X or 10X and lost 50% of equity (assuming it was at least about 40%). Loss of 50% is one thing; years to recover is another. If I am young, employed (or at least employable), then I can somehow survive. If I am in my 50s? Then I will be forced to become conservative.
My son‘s future portfolio: This has about 58% equity, and if the stock market falls by 50%, the overall corpus will drop by about 28-30%. I can still manage his college education. Again there are two factors at play: starting early (I started from 60% equity, 40% debt corpus a month before he was born. and is 11 now) and, as always, luck.
Let me reiterate. These are theoretical ways in which I could react. I do not know how I would respond, but I now have a document of possibilities ready. Will I remember or bother to read it then is another matter, but at least it is in place.
It is sheer luck that, at least in theory, I can manage the loss in value and, more importantly, time. I would urge you to think about this and share (on FB group Asan Ideas for Wealth) or on Twitter how you would cope. You can also comment on our YouTube community page.
Are there any lessons from this? People talk about the “power of compounding” and the importance of starting early. The truth is, starting early in the capital markets is the best ways to manage risk because most of us invest without a plan; we hope the markets will not fall that much or will not stay down for that long. By starting early, we maximise our chances of getting lucky too. Even if we do not have a plan, to begin with, starting early could minimise “time loss”.
Now the question to ask is, “yes, luck matters, but can I provide some assistance to luck with a plan that is robust enough to handle lost value and time?” It will not be fool-proof, but can I at least attempt to install a fail-safe?
Yes, but we need to look at our portfolio in a different light and go beyond “I got 700% XIRR after 13 days of mutual fund investing”. Every year, I would recommend asking the following questions:
- What is my portfolio worth? If I liquidate it today, “how long can I live off that?”, if it is for retirement or “what product or service can I afford?”, if it is for something else.
- Are the return and inflation assumption made in the plan reasonable, or should I change then?
- What corpus should I have by now as per my plan? What is the actual corpus? If the corpus is less, is the gap too much? If the gap keeps increasing, should I change my asset allocation to lower risk?
- What is my strategy to derisk the portfolio? Can I lower risk so that no what returns the market throws at me, I have a reasonable chance of getting close to my target corpus?
By asking effective questions such as this, when the going is good, there is a reasonable chance that logic will not entirely abandon us when the going is bad.
If we plan well, we can (rightly) attribute the past to luck. If we do not plan, we will have to rely on luck in future.
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