What if market crashes? Do you have your contingency plan ready?

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What degree of market fall is supposed to be normal? The simplest way to understand this is to refer to the past behavior of equity markets. The chart shows the largest intra-year fall recorded during each year in Sensex for the last 40+ years.

largest intra-year fall recorded in Sensex for last 40+ yrsET Online

Did you notice something? Around 10-20% fall is almost a given every year. There were only 3 out of 41 years where the intra-year fall was less than 10%. But despite the equity markets going down every year this is how the long- term returns panned out.

Only 3 out of 41 years where the intra-year fallET Online

But why does this happen? Equity investing for the long term finally boils down to human progress and entrepreneurship. Thanks to the ingenuity of Indian entrepreneurs, Indian equity markets have always recovered from market crashes and continued to perform in the long run.

Indian equity markets crashes and recoveryET Online

But what about the first chart, where markets had a fall every year?

While we showed you the highest intra-year fall, we didn’t show how the year finally ended in terms of returns. Here you go…

Graph 1 with returnsET Online

Out of 41 years, while markets always had an interim decline, only in 9 years did the market end the year with negative returns. In other words, for 32 out of 41 years, the markets ended the year in positive – despite the temporary decline in between. So it is not as scary as it initially looked.

This essentially means occurrences of 10-20% temporary declines are normal and we should in fact be surprised if they don’t happen. The Sensex touched a peak of roughly 52,000 a few months ago.

Since a 10-20% intra-year decline in equities is common, Sensex falling to 47,000-42,000 levels should be a normal part of expectations.

Where is the Sensex now? Around 48,500 levels. Is this something about which we should be surprised? What about the ‘Not-So-Normal Declines’ in Equities? Once every 7-10 years, equity markets also witness a sharp temporary fall of 30-60%.

Historically, during such deep temporary falls, it has taken around 1-3 years for the markets to recover and get back to original levels.

Table 1ET Online

But this is where it gets tricky. All the 30-60% falls should logically start from a small 10-20% decline. How do I know which is ‘Normal Decline’ and which one is actually the start of the big one?

The best way to find the answer is to find out the best investors who have done this consistently and learn from them. But, here is where there seems to be a small issue. Can you name 5 investors who have ‘consistently’ identified bear markets, stepped out before the fall, and entered back at the bottom? You can take all the time you want. If you are finding it difficult to find even one name – no worries. You already have your answer.

So does it mean, we stay invested in equities at all points in time irrespective of the market conditions? While timing large market falls is extremely difficult, here is where we like to bring in some nuance. We take a humble yet pragmatic approach where around 90% of the time we stick to the view that we cannot predict equity markets.

But for the 10% times when markets are at their extremes (as per our framework) we would like to adjust and adapt our portfolios to a certain extent.

The keyword here is ‘to a certain extent‘ – as bubble markets may last much longer than we expect or we may be wrong in our judgement of what constitutes an ‘extreme’. Hence we don’t take extreme ‘all-in’ or ‘all-out’ decisions from equities.

So, when do we reduce equity allocation?
When we studied past bear markets, we noticed that the odds of a large market correction is high when three conditions come together

  1. Very Expensive Valuations
  2. Top of Earnings Growth Cycle
  3. Euphoric Sentiments

Under these extreme conditions, we prefer to be underweight in equities (read as reduce equity allocation) and shift a portion to Dynamic Asset Allocation funds.

But what if markets end up with a huge crash?

Just because our framework is not indicating a bubble doesn’t mean the market can’t have a big fall. Remember all the experts who tried being overconfident.

We completely acknowledge this possibility.

While we think the odds are low, however we always want to be prepared to make use of the opportunity if the market falls more than 20%.

Prepare a ‘What if things go wrong ’ plan

Pre-decide a portion of your debt allocation (say Y) to be deployed into equities if in case market corrects

  1. If Equities Fall by ~20% – Move 20% of Y into equities
  2. If Equities Fall by ~30% – Move 30% of Y into equities
  3. If Equities Fall by ~40% – Move 40% of Y into equities
  4. If Equities Fall by ~50% – Move remaining portion from Y into equities

*This is a rough plan and can be adapted to based on your own risk profile

This helps us to make peace with our portfolios and the unpredictable markets.

So if you still haven’t built your ‘what-if-things-go-wrong’ plan, this is the best time to do it.

The author is the
Head of Research at FundsIndia)

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