June 10, 2022
Sid Roy
We had a fantastic session talking about Investment Discipline in Market Volatility. The session could not have been more appropriate given everything that is going on in the world, the economy, and the investment market.
We started noting this irony. We are doing a session focused on managing and responding in a disciplined way to market volatility. Yet, if we really followed sound investment principles, we would be taking a long-term outlook and instead we should be ignoring everything going on in the market. So, if you are not in the camp of people who have been checking stock prices every day and the value of their portfolio every day, then you deserve congratulations. You might even not need to read through this article.
I am not yet fully there. I have an innate curiosity about market dynamics and the saying “curiosity killed the cat” might apply to me one day. For a while, it was hard for me to stomach this downturn much as I thought I had mentally prepared myself. I confessed that I have always wished if I could sell and buy back the same stock at a lower price. So here I was – hopefully a model investor, well informed and all that, still struggling to work my way through this.
That led us to a discussion of the different types of investors – someone who is a model investor (I think of myself here) – knows about basic investment principles, invests for the long term with a goal in mind. This model investor (me!) still has a lot to learn. So, we got into the discussion of the different types of mistakes that are common and why these mistakes might happen.
First, it might be helpful to talk about why a model investor might make mistakes. She may have made the right moves before but there are two things that might trip her up. One is a misunderstanding of her risk capacity, and another is an incorrect assessment of her risk tolerance. Risk capacity is really about someone’s concrete financial situation and financial needs. Given a certain amount of funds, does it cover for your essential needs in the future? Risk capacity is not that hard to assess but it can change over time depending on your situation. Let us say that next year you inherit a large sum of money. This event would change the amount of funds at your disposal and thus your ability to meet financial needs. Any kind of financial investment carries with it a certain risk of volatility of return. Generally, the higher the expected return, the higher the risk is. Your inheritance just made it possible for you to aim for higher returns at higher volatility risk. This is risk capacity.
Risk tolerance is another matter altogether. Risk tolerance is the amount of risk that an investor is willing to take. This is a personal matter. And almost without exception, most of us lack a concrete sense of our own risk tolerance. In good times we tend to overrate our tolerance for uncertainty. The moment the risk starts unfolding, our actual risk tolerance shows up and it might be much lower than what we thought. None is fully immune to this.
The model investor gets tripped by both these factors. First, the model investor may have chosen the right investments based on her goals, but she may not have explicitly thought of her risk capacity. Usually this happens due to our recency bias on the performance of the investments. Just like me, I am sure there are other people who do not have a good sense of their risk capacity – as in how much of a downturn can they deal with, and how long a downturn they have the funds for.
Without a good sense of her own risk capacity, the model investor does not have a good yardstick to keep her calm. And then, her actual risk tolerance kicks in. She loses nerve and she bails out of her thoughtful investment strategy. She might divest the portfolio that has suffered recent losses and move to different investments. Or she might be even more uncertain as the market goes up and down multiple times. If she was hoping to buy the stocks she sold cheap, then she is disappointed as the market goes further down. Worse, she might lose confidence in the investment market and not benefit when the market turns again.
So, what recommendations do we have to avoid such a loss? First, it is important to get a good sense of your personal risk capacity. A good approximation for this is – to note the maximum drawdown and the duration for which investment portfolio might be underwater. Second, it is important to get used to the likelihood of drawdowns and the extent of drawdown periods. It is best done taking a wide time horizon. Given your portfolio, what is the worst drawdown and what is the worst drawdown period over the last hundred years, and then, be prepared for that. So, in summary, the recommendation is to take a long-term approach and stick to your investment strategy.
Now, what does that mean in practice? If you have an investment strategy that you have put together based on your goals, you should stick to it and ignore the market completely. That is do nothing different. As long as you accept that markets will go up and down, and your investments are going to vary with the market, you will be fine.
Suppose you have mastered this already. You have been a stoic and you have maintained course. What more can you do? There are a few other suggestions that came up that might be helpful. One is – if you are expecting to rebalance and looking to purchase some stocks that look cheap, you might want to take the opportunity and may be buy it earlier than your normal timetable. Two is – there are some cases where lack of liquidity creates opportunities to buy something at good value. Closed End Funds are an opportunity since they are illiquid and under market turmoil, they may get cheaper than reasonable.
All these talks of cheap investments naturally bring up another question – what is cheap? When there is so much seesawing in prices, how does one know if something is cheap. For example, I look at SaaS companies quite a bit, especially emerging ones. The valuations of these companies are changing every day. It is hard to know if we are seeing rock bottom prices. It is hard to judge if they are cheap even for me. A better way might be to look at long established companies (or funds holding such company stocks) – companies whose products and place in the market is very well studied, whose valuation is very well understood – these companies might see an outsized drop in value due to market volatility. These companies especially those that are part of everyday staple, might be a better place to focus on while staying consistent with your investment plan. Well, that was quite a lot! We will have another session next month on this topic since there is still so much ground to cover. We hope you liked the session, and we will see you next time.