A few days ago Sensex and Nifty experienced their first negative yearly return. Many new equity mutual fund investors are worried and wonder what to do. The standard answer to this in social media is, “be patient and wait. This is how the stock market behaves. It will all work out in the end”. Sadly, although well-meaning, this advice is inappropriate for most investors.
To appreciate why all we need to do is ask the worried investor three questions: (1) When do you need the money? (2) What is your asset allocation? (3) What return do you expect?
The answer to the first question varies from 3 months to 30 years. The answer to the second varies from 100% equity to 50% equity with the rest in fixed income. The answer to the third is relatively narrow in its range: from 12% to 18%.
Take for example a person who needs the money in three years has an asset allocation of 50% equity and 50% fixed income and expects 15% from his equity mutual funds.
He should not have chosen equity at all if he needs the money in three years. Therefore the asset allocation is also inappropriate and the expected return irrelevant (it is irrelevant even for long-term goals but that is another matter!).
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Waiting for equity markets to revive is like gambling his hard-earned money. Unfortunately, there are scores of other investors in the same boat. In fact, we feel that the recent bull market has made many young earners overconfident about the stock market. Many of them seem to have thought the party would never stop. It did stop and how!
Yes, patience, perseverance, discipline and all such nouns are most relevant to equity investing but only to truly long-term investing. If my need is 15 years away from now and my asset allocation has 50%-70% equity and my return expectation is 10-12% after-tax*, I can certainly afford to continue investing during the present downturn and be patient, provided I have a clear equity-weight reduction plan well before the goal deadline.
If I need the money less than 15 years from now, I will not have equity of more than 50% unless I have already achieved my goal and the value of the fixed-income portfolio is significant. If I need money 10 years from now, I will reduce equity exposure even further (regardless of whether the market is currently in an uptrend or downtrend).
* Many young earners are annoyed at our recommendation of no more than 10-12% equity return expectation post-tax. It is important to recognise that these are returns expected after 10Y, 15Y or longer. The equity market will not be as rewarding as it is now. See: Ten-year Nifty SIP returns have reduced by almost 50%.
Waiting for the stock market to recover is the right approach only for those with reasonable return expectations; suitable asset allocation; step-up systematic investing and step-down systematic equity reduction strategies. All this talk of “compounding” and “exponential growth” means nothing without a plan.
For everyone else, waiting out a market downturn is the same as gambling their hard-earned money. Our money deserves much better respect. Those who do not have time on their side are better off exiting their equity mutual funds.
Thankfully those who do have time on their side can learn from their mistakes and plan better. Try this if you would like to get started the right way and create an investment strategy independent of market conditions: Basics of portfolio construction: A guide for beginners.