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Don’t get too comfortable with equity: This is how a real market crash “feels” like

So you think you have become financial literate by starting equity mutual fund SIPs assuming that they will beat inflation in the "long run"? Don't get too comfortable with equity. Don't assume those fairytale returns from DSP nanocap fund will last. This is how a real market crash "feels" like.

Preparing for a presentation can be really fun when you have to make all new slides. I got a gig at the RBI staff college next week and as I was preparing to give the audience post-lunch indigestion speaking about the market-risk, I thought it would be a good idea to turn them into a series of posts about risk (what else!) and what we need to know about the great industry/media propaganda - the SIP.

In part one, I simulate a "real" market crash.

First, we start with the NAV movement of Franklin Prima Fund

Excuse the reference to "blue dots" that is a cut and paste overkill.

Now, let us look at this in the proper perspective by using a logarithmic scale. This will divide the vertical axis into equal sized chunks. I prefer the log to the base 10 rather than the usual log to the base e (or ln) as it is more granular. Those who are new to these type of plots may consult this post: Are you ready to climb the Sensex Staircase?!

Notice that the recent increase does not seem so steep because now you can see that relative to past growth. Now let us focus on the dot-com crash.

This is how the NAV fell. Those who consider a 1% o r 2% drop as a crash may kindly imagine what this would do to a portfolio.

Now, I would like to imagine the above % monthly change in NAV to be repeated from next month on. Of course, this is a pure speculation based on cherry-picked data. But cherry-picking reward is different from cherry-picking risk. The former is delusional and the later dreadful. And I would always choose the latter.

Fasten your seatbelts!

The red dots are simulated. Why is a crash that "looked" so mall in 2000 appearing so gigantic now? Again, because we are not looking at in the right perspective.

Both the crashes are essentially identical. The heights of both arrows are the same. This si the power of the log scale (log 10 scale to be precise due to the 0.5 granularity in the vertical axis.

The standard log to the base e or (ln) graph will look identical but notice the y-axis.

Please do not assume this crash simulation is a fantasy.

Please do not assume the SIP corpus will ensure market will never crash. That is garbage. If and the when the FIIs pull out, the market will head south. As simple as that.

So what would happen to the great SIP due to such crashes? To be continued .....

Ps. Of course this, is a simplistic illustration of a crash. The point is, to be forewarned is to be forearmed.

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11 thoughts on “Don’t get too comfortable with equity: This is how a real market crash “feels” like

  1. Pradeep

    Wow, thats an excellent presentation Prof.
    Scary and our only prayer is that if such a fall happens, hope it happens a good 5-6 years prior to my reaching a goal. Obviously it wont be that way for everyone since each one will reach their goal in a different year.
    One small positive from that scare is that the NAV multiplied by 20 times in the 5 years after that 2001 fall and by 60 times in 15 years to reach where we are today at nearly Rs.900.
    So it makes me think we need such a fall so that it can go up in the subsequent years.

    Reply
  2. kalyan

    (Posted the comment as question at first 🙁 )
    It can be very quick too. If you see the graph, the fund lost more than half in less than 2 months at the beginning it self and then lost around another third gradually for a total loss of two thirds. I checked SBI Magnum Balanced fund which lost 50% in less than 2 months around same time which means even balanced funds will not be spared the carnage.
    I always thought we need to have some stop loss measures for indices and mutual funds too but never did any analysis so far. May be it is time to do some work on that aspect. For all the talk of not timing the market, a conservative investor too should have rules to when to sit out even at the risk of missing out the start of rally. But it is difficult task due to the nature of crashes. If you see the graph you can see rallys of more than 10% periodically within the overall crash.

    Reply
    1. freefincal

      I have mentioned several times about systematically reducing portfolio risk. That is as important, perhaps more important than investing systematically.

      Reply
  3. Srini Sundararajan

    Dear Pattu:
    Very well illustrated post.
    This is the MAYA of two things:
    1. % Change .vs. Absolute Change. If the worst case scenario fall is 60%; it shows as 60 Rupee drop on a NAV of 100; but it shows as a 600 Rupee drop on 1000 Rupee NAV. Yet, when we cannot see that visually - we are not able to internalize quickly.
    2.Most of the times, I find we all do not intuitively get there's a big difference between % on the downside and upside. The downside % is RESTRICTED to a MAX of 100% the UPSIDE % can go even into 1000% and up theoretically to infinity. So, if we are offered a -50% followed by a +90% fund, and another with a -25% and a +45% fund. Many of us feel that the first one will give me more returns... but the reality is different.

    Reply
  4. Bashyam

    Dear Pattu, Thanks a lot for this post. Statistics in all situations is statistics. And for the individual nearing the goal post, all he /she wants is not statistics, it's the expected money.to hold..else there will be hardly anything to SIP

    B/w, your statement "Please do assume the SIP corpus will ensure market will never crash"

    Did you mean to say "Do not"?

    Reply
    1. freefincal

      Yes "do not". Corrected. Thank you. It is "statistics" that reaches some people to protect the corpus systematically and not just when the goal is near.

      Reply
  5. krishna

    Nice illustration of how things will be when a crash happens. Regarding your statement "If and the when the FIIs pull out, the market will head south", I think there is a basic difference between year 2000 and now, in the sense that, there is a lot of domestic investor participation via mutual funds, compared to what it was in at that point. So I think even if FII's withdraw, the correction should not be so steep. Even if domestic investors run to get out, it might be more protracted,as most of the investments are via mutual funds, who will scramble to put some safeguards in place(or am i living in lala land :P)

    Reply
  6. Shan

    Excellent post, Michael Batnick did a similar one a few days ago - http://theirrelevantinvestor.com/2017/06/24/this-is-your-nightmare-scenario/

    Given that our markets are in the overbought territory it's best to prepare for this. Here are a few things I can think of:

    1. Tail risk hedging by buying deep out of money far puts. See this for instance http://mebfaber.com/2017/06/15/nervous-market-might-time-strategy/ and in general the book "The Dao of Capital" by Mark Spitznagel is an excellent read. His video here is a great intro too https://www.youtube.com/watch?v=LyGtiiGBEc8

    2. Go conservative with a higher allocation to bonds based on valuation. One of the simplest ways of doing it is dynamic asset allocation funds like Franklin Dynamic PE Ratio FoF which moves money to debt funds when markets are expensive and back to equities when markets are cheap. Perhaps the easiest way to be contrarian with minimal effort and be relatively safe. (But don't expect phenomenal returns)

    3. Slightly more aggressive, rebalance with a fixed proportion, something like 60:40 in stocks/bonds or 70:30 etc. Do this without sentiments and without listening to so-called "experts". Hard to do when a big crash happens but if you can pull off it's ideal. Most balanced funds can give you this option if you don't want to DIY.

    4. Do nothing but hold your equity portfolio for a very long term (decades!). This requires nerves of steel, though and a deep conviction regardless of any bad news.

    Reply
  7. Saisundar Ramachandran

    Thanks a lot for the post sir. Though I knew log is a better way to look at returns than linear chart, this post (and the link to stair case sensex) made me understand the logic behind log.

    The recent positioning of SIPs as "sarava roga nivarini" by fund houses and encouraging retail investors to sign up gives me doubt if these fund managers are expecting a FII pullout/crash and hence building buffer against it.

    Reply

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