March 2020 : Covid 19 Effect on Financial Markets

The past couple of weeks in the financial markets was a testimony to the fundamentals of investing and my belief in them . Until Feb 2020, investors were enjoying a long period of bull ride resulting into significant regular monthly investments in the equity mutual funds/ high performing stocks which had maintained a track record of 13-15% returns over the past half a decade. A majority of the new retail investors felt that they have found a simple gold mine to make significant returns (through smart & intelligent fund managers who are being paid to just do this) and started thinking to themselves ” why did the previous generation of parents and grandparents miss this route to make money. Why did they continue to invest in Fixed deposits or PFs or PPFs neglecting the earning potential of Corporations “.

As has always been the case in downfalls, markets need a prick to return to fundamentals and this time it was Covid -19 which led to severe downfall in the market valuation . The bullishness suddenly converted into fear as the global markets collapsed and investors rushed out of the markets and started doubting their investing philosophy that they had been religiously following for 3-5 years, thanks to the past performance, social pressures and aggressive marketing by AMCs. Majority of these investors were first-timers and were ready for minor fluctuations in the market (negative 10-15%), but not at the levels seen in a week. The inexperience of dealing in these type of events eventually led to a panic for a significant number of retail investors.

Here are the beliefs and emotions that I have been observing in the market place over the past 3 years , eventually leading upto the current market situation –

  1. Excessive bullishness and above average past returns – The successful 1-3-5 year returns of mutual funds brought excessive bullishness in their potential . A major lot of investors who had been investing in SIPs in mutual funds continued doing so , without being aware of the burgeoning valuations in the market as they steeped up their returns .

On the contrary , major reputed investors (Warren Buffet or Howard Marks) have been for quite a long time now, doubting the capability of markets at current valuation to sustain . A significant lot of other experienced investors also had a sense of bubble in the market, however, as is typical, no one could predict the timing of a possible crash. Fund managers whose livelihood depends on “Assets Under Management” naturally convinced retail investors of the continued possibility of higher returns in the market. Unfortunately, their advice was flooded in all sources , be it newspapers or TV channels . The information overload of such advice along with the inertia of continuing SIPs , led to retail investors continuing the path of equity investing (via stocks/SIPs) even in an overvalued market.

Secondly, even if some investors had a sense of market overvaluation, there was a fear of losing out. They didn’t want to go against the inertia and current trend when they can’t predict the timing of market correction . Added with it , the scare that if the market downfall doesn’t happen for next 1-2-3 years, they will miss the bus and the possible opportunity for higher returns. These thoughts eventually led to a decision to stay invested than miss out the bus even if they weren’t fully sure of the rationality of the decision.

Fundamentals of investing requires you to be aware of your odds of success in the market place. Every investment you make in the market (even if it is a fixed monthly investment you make via SIPs in the funds) need to be rationally evaluated against the second alternate investment class (lets say the fixed deposits to be simple). The higher the prevailing market valuation, the lower becomes your chances of beating Fixed Deposit/PF , not eliminating the increased possibilities of significant capital loss. Awareness of this fact should rationally lead an investor to be conservative and cautious while investing the hard-earned money. Successful investors who make money in long run are able to hold off their zeal to invest in equity markets for years, till the time the valuation is justified within their range. This was the major reason why Buffett kept sitting on a pile of cash for long and Howard Marks warned investors to be cautious in investing in market in current scenario.

  1. All of a sudden a 30%+ drop in equity portfolio led to shocks which impacted the investors’ capabilities to take the benefits

When investors suddenly see their portfolio (which was 15% up and is currently down by 20% in two weeks ie overall 35% decline), it leads to a bearish situation where the first course of action is to stop their regular investments, forget about increasing the amount of investments in these tough times. The shock of sudden loss overpowers any thinking of a favourable scenario in the future.

The above graph depicts how proportionate fall in your portfolio valuation hampers your psychological nerve to invest further.

If you had decided to stop your equity investments in the overvalued market situation for quite some time now (as described in point No. 1), and rather preserved cash, it would have been a prudent strategy . This would have helped in two ways- Firstly, it would have decreased your probability of loss and secondly, provided available capital to take advantage of market downfall .

Wisdom advices you “to preserve sufficient cash/liquidity to keep your expenses going. Market downturns can be associated with situations of job losses and having funds in such scenario is critical for emergency personal expenses as well as to jump on investing during the market crash opportunities

  1. Fear of Missing Out in market downturns – Even for those, who have been waiting for such opportunities by preserving cash to invest, psychological challenges remain on the ability to make sound investments and maximising returns.

One of the major emotion is ” Greed and Fear Of Missing Out” in such market crash opportunities. It is natural that there are two possibilities- market may go up from here, or may further go down. These opportunistic investors are always worried about the scenario of market going up from here (what if suddenly tomorrow market jumps 15% up and this downfall was short-lived) and they don’t deploy all capital and miss out on low valuations . On the other hand, they are worried if the market drops another 20% in another week and they don’t have additional money to deploy. Sometimes , this pyschological behaviour also leads them to borrow additional money to continue taking advantage of low valuations. It brings a mental conflict on how to effectively deploy the capital.

One of things to remember here is that it is a factor of luck and is completely un-predictible whether market will go up or down tomorrow, a week from now and so -on. No-one can be perfect to be able to time the market and invest at the lowest valuation points. It might happen out of luck with a few investors, but would be very low % of total investors. Trying to aim for such outcome will only lead to stress and psychological dysfunction affecting rationality. As Howard Marks mentions “the best way is to spend a part of your targeted investment . Tomorrow, if the market goes up, you’ll be glad you bought some.  Alternatively, if it continues to go down, you’ll still have money left and hopefully the pyschological nerve to buy more.”

  1. Not maintaining an optimum Fixed Income/Equity ratio , believing simply in Formulas propagated by Fund Managers.

A lot of investors blindly believe in the magic formula –

Equity investment (% of portfolio) = 100- Age

Lets take a classic example of a 30 year old young investor. Lets assume his total wealth is 50 lakhs (he has no other assets) . If he believes in the classic formula (Case 1), he would have 35 lakh (70%) in equity and 15 lakh in fixed income at one given point. Lets look at variations of his portfolio in three scenarios- Good Times, Normal Times and Depression /Crashes.

Case 2 compares a fairly conservative portfolio distribution of the same individual (now 70% fixed income investment and 30% in equity)

Typically, when one structures his portfolio with higher equity proportion, he considers fixed income as a return destroyer. As given in table in Case 1, his portfolio fluctuates between 16% in good times, 9% in normal times and upto -33% in depressions/crashes. Even if you may have time at your side to recover losses during crashes, the question remains whether you have the appetite and capability to bear loss of a third of your wealth at any given time, as well as your mental strength to continue investing in such market crash situations. Some people get overwhelmed by one time losses that , forget about their abilities to further invest to take benefits of market crash, they eventually exit the market altogether.

 Equity: + 20%
Fixed Income: + 7%
“Good Times”
 Equity: + 10%
Fixed Income: +7%
” Normal Times”
 Equity: (-50%)
Fixed Income : 7%
” Depression/Crashes”
 Portfolios return : 16% (+8 lakhs)
 Portfolio Return: 9.1% (+4.5 lakhs)
Portfolio Return : -33% (-17 lakhs)
Case 1 : 70% Portfolio in Equity
Equity : + 20%
Fixed Income : + 7%
“Good Times”
 Equity: + 10%
Fixed Income: +7%
” Normal Times”
 Equity: (-50%)
Fixed Income : 7%
” Depression/Crashes”
Portfolio Return: 10.9% (+ 5.45 lakhs)Portfolio Return : 7.9% (+3,95 lakhs)Portfolio Return : -10.1% (-5 lakhs)
Case 2 : 30% Portfolio in Equity

In Case 2, on the other hand, his portfolio fluctuates between 10.9% in good times, to 7.9% in normal times and worst case scenario of -10% in depression times” . A person in such portfolio structure would not lose more than 10% even in the worst case scenario . He is more likely to be psychologically sound and continue investing to take benefit of market falls.

The above graph depicts how in Case 2 , when the portfolio is tilted towards higher proportion of fixed income, your psychological nerve to invest further during the market downturn is higher

Consider these situations and take your time to think on how would you want your portfolio to be structured for mental stability and long-term superior returns. This is the most important decision to keep you winning in the long-run.

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