How to prepare for what you can’t predict

By Morningstar |  19-10-20 | 

When volatility raises its head, our instincts rise to the surface and our actions become reflexes. Investors who did well in risk questionnaires find that the reality of a drawdown makes them queasy.

No one can predict the arrival of events that impact the markets. Even if we do, we are unable to predict the magnitude of impact. Which makes reality all the more harsh.

Mahesh Mirpuri believes that preparation is the key, and shows us how we can rely on a time-tested investment philosophy. Read on.

When I was in school, three of us often hopped onto public buses to explore Chennai. The journey was notorious for its bumps, sharp turns, sudden breaks and dramatic sways. We would be shoved and thrown around if we never watched out. My strategy was to grab a holder or the seat in front of me. One of my friends followed the identical motion but used both hands to play it safe. He latched on to all the support provided. The third was the complete opposite. He took the tumultuousness in his stride and at times, even enjoyed it.

Three friends. Identical in so many ways. But such starkly different responses.

Apply that analogy to your investing journey. Add to it the uncertainty of reaching your destination (your articulated financial goal). It will give you an indication of how investors, seemingly identical, have such different temperaments.

In times of volatility, don’t just see your portfolio, watch your behaviour.

How do you feel? How frantic do you get?

No quiz or questionnaire can ever prepare you for market volatility. Reality is completely different. To actually see your portfolio undergo a tremendous loss in value can evoke startling emotions.

Some can take all the volatility and not bother because they have the mental make-up and capacity to take such risk. If they do, they have the ability to zoom out and see the entire situation objectively. Of course, it helps having a steady income or a secure job or being financially stable.

It may jolt others but not provoke them to act impulsively.

But from my experience, it is a shattering experience for most investors. May I say that for majority of investors, going through a huge drawdown can be a shattering experience mentally. Even financially, they are not prepared to recover from a 50% drawdown in equities.

What is the way out?

It is simple. Asset allocation. It provides insulation against volatility and makes the entire journey to your destination much smoother. It provides stability. Refer to the bus example of encountering sharp movements. We reached out for support, an anchor.

The first step to creating any portfolio is to decide on the equity and debt combination. The equity part provides the growth and the bulk of the returns. The debt part plays the role of the anchor, providing a stable base to you during periods of volatility.

The allocation to equity will rest on three factors: when you need the money, an honest appraisal of your capability for risk, and the volatility you can stomach.

When it comes to debt - which will be the stabilising "anchor" part of your portfolio, naturally, there are two aspects you must never lose sight of: Safety and Liquidity. I say this because the prime aim of debt is capital preservation and stability to the overall portfolio. It is supposed to make it easier to stomach risk elsewhere in the portfolio. Investors can inadvertently sabotage their portfolios by trying to juice returns by adding risky debt (low-rated paper that gives higher returns or credit funds).

When it comes to the debt portion of your portfolio, think stability. Be it liquid funds, ultra-short term funds, bond funds, fixed deposits, or small savings, their purpose is to provide liquidity and stability.

Consider gold also as part of the 'stable anchor' part of the portfolio.

When markets are volatile and there has been a drawdown, it is the worst time to make a dash for safety or scramble for liquidity.  

You would be selling a loss. This will have financial and emotional repercussions. You can sidestep this by providing stable anchors to your portfolio. This will keep you calm and objective during the inevitable volatility you will see in the equity part.

In the financial journey, there is more uncertainty than in a bus journey. And a lot more at stake. Tread cautiously and be prepared and allocate wisely.

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ninan joseph
Oct 19 2020 06:47 PM
 I fully agree with the author. The first and only step is to do Asset Allocation and when I say Asset Allocation, it means First priority is for Fixed deposits with BANKS to cover your living expenses. Once this is covered all sorts of permutation and combinations can be exercised. But if you do not cover yourself it will be like the third friend, a sudden break will lead to his head being crushed by the windsheild of the bus.....
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