Last Updated on October 24, 2021 at 6:55 am
Sriram has an interesting question: “Dear Pattu sir, thanks to your articles, I have just started investing in equity mutual funds with a 15-year goal. For the fixed income part, I would like to use a combination of fixed deposits and gilt mutual funds”.
“My asset allocation is 50% equity and 50% fixed income. As a newbie investor, I am scared of market crashes. Can you please write an article on how much loss a long-term investor should expect during the investment journey and how to prepare for this mentally?”
First, let us consider past data to appreciate the loss we expect from equity or equity mutual funds in an investment portfolio. Then we will get to the hard part – preparing for this, first via prudence and then look at the mental aspects.
When it comes to investment return expectations, past performance is not an indicator of future performance. However, when it comes to investment risk expectations (for those who bother to), risk in the past is the bare minimum we should expect in the future.
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So for a 15-year investment duration, the maximum loss a 100% equity portfolio has suffered in the past is 61% (maximum drawdown). This is one aspect of risk. The other is time. The longest duration for which the portfolio was below an all-time high (max underwater) was 40 months! That is three years and four months!
So for a 50% equity 50% fixed income portfolio, the maximum drawdown (MDD) expected is about 31%. That is, the entire portfolio is reduced by 31% at some point (not just the equity part!)
In backtesting with Sensex and a gilt index as the portfolio components, the MDD was also 31%. When the gilt is replaced by a constant interest rate (a proxy for an FD), the MDD is about 31%.
The maximum underwater duration was 22 months with gilts and 27 months with FD. That is, the entire portfolio underwater for about two years (not just the equity part!)
Notice how the volatility of gilts helps lower portfolio risk better than a fixed interest instrument. Read more: If equity MF returns are negative, will gilt MF returns be positive?
Asset Allocation Risk Matrix
Next, we present a risk asset allocation matrix. This is the minimum risk an investor must expect to face in terms of loss of value or loss of time for various equity exposures.
Please note that it is childish to presume loss is notional. Until we redeem, both losses and gains are notional! Real-life is a lot more complicated than what mutual fund guys would have us believe.
Depending on the sequences of returns studied, the actual loss one would face may be higher or lower than this.
The maximum drawdowns of the entire portfolio for different equity allocation is shown below when gilts and fixed interest instruments are used for the debt component. The numbers for any other debt fund can be reasonably expected to be in between these two extremes.
| Equity exposure | MDD gilts | MDD FD |
| 100% | 61% | 61% |
| 90% | 56% | 56% |
| 80% | 51% | 52% |
| 70% | 45% | 46% |
| 60% | 38% | 41% |
| 50% | 31% | 34% |
| 40% | 23% | 27% |
| 30% | 17% | 19% |
| 20% | 12% | 10% |
| 10% | 8% | 3% |
| 0 | 8% | 0% |
The continuous months the entire portfolio was underwater for different equity allocations is shown below when gilts and fixed interest instruments are used for the debt component.
| Equity | CUW gilts | CUW FD |
| 100% | 40.00 | 40.00 |
| 90% | 39.00 | 39.00 |
| 80% | 38.00 | 39.00 |
| 70% | 32.00 | 38.00 |
| 60% | 26.00 | 32.00 |
| 50% | 22.00 | 27.00 |
| 40% | 20.00 | 23.00 |
| 30% | 16.00 | 19.00 |
| 20% | 16.00 | 16.00 |
| 10% | 10.00 | 6.00 |
| 0 | 16.00 | 0.00 |
How to prepare ourselves for this loss?
A two-step process is necessary here: prudence and mental training.
Prudence
The following steps will remove a significant chunk of uncertainty associated with the stock market.
- Know when exactly you need the money
- Have a realistic estimate of inflation
- Don’t expect too much return from equity or debt.
- Don’t forget about taxes!
- Choose an asset allocation with a good chunk of fixed income: 40 to 50%.
- First, compute the expected portfolio returns after tax for this asset allocation. Then compute the investment required. For an example, see: Retirement plan review: Am I on track to retire by 50?
- Have a plan to systematically de-risk the portfolio with rebalancing and varying the asset allocation. For an example, see: I am 30 and wish to retire by 50; how should I plan my investments?
- Learn how to review your portfolio effectively. See, for example, How my retirement portfolio has performed in 2020: personal finance audit.
- Invest systematically regardless of market conditions. Also, see: Myth Busted: Investing during market dips will result in more returns.
- Invest as much as possible, increasing your investment by at least 10% each year.
- Unfollow all financial news, in particular, freefincal.com and develop a productive hobby or alternative income streams. Read more: How to earn one lakh a month passive income?
- All you need is 30 minutes a year to review your portfolio.
Mental Training
How to get used to market loss?
We are emotional beings, but we need to be emotional about the right things. For example, after I started investing for the first few years, my equity portfolio return was zero (I didn’t know the overall portfolio return at that time).
The only reason I kept going was because I was emotional about the future. I was ready to face loss in the short term for an opportunity to change my social station in the long term, and it paid off. My journey: driven by the fear of making the same mistakes again.
A counterintuitive way to get used to market loss is to embrace it wholeheartedly. Today you are losing Rs. 100 or Rs. 200 per day on your equity investments.
Tell yourself that you look forward to the day when you would lose thousands per day and then ten thousand per day and then lakhs per day and then crores per day. Meaning you also stand to gain the same kind of amounts.
Do everything possible to prudently manage risk on auto-pilot and embrace the loss as a necessary step on your way to becoming a multi-crorepati.