Indian equity markets are down 10-15% in the last few months. Will they fall further? Unfortunately, historical evidence suggests that it is impossible to consistently predict short-term market movements. So, how do we deal with this dilemma? Here you can use ‘preparation approach’ vs ‘prediction approach’.
The preparation approach consists of 3 phases:
Understanding the historical odds of temporary market downturns: The history of the Sensex over the past 42+ years shows that the Indian equity markets suffer temporary declines of 10-20% almost every year. There were only three out of 42 years when intra-year declines were less than 10%. When seen from a historical point of view, the recent decline is completely normal and not surprising. Large temporary declines of 30-60% are rare and usually occur once every 7-10 years. We must learn to accept and tolerate a temporary drop of 10-20% every year and a 30-60% drop once every 7-10 years. A temporary drop should not be viewed as a ‘penalty’, but as an ’emotional fee’ that should be paid for long-term equity returns.
Pre-loaded Decision Scheme to Increase Equity Exposure During Downturns: History shows that despite several crises, Indian markets have always recovered and have gone up over the long term (reflecting earnings growth). You can use this to your advantage to invest more in equities during sharp market downturns.
This can be done through a crisis plan where you pre-decide to deploy a portion of your debt allocation or new money (like Y) into equities on a market correction. For example, if the market falls by 20%, transfer 20% of Y to equities, if the market declines by 30%, transfer 30% of Y to equity, if the market drops by 40%. % declines, then transfer 40% of Y to equity. Equity, and if the market falls by 50%, transfer the remaining portion from Y to Equity. You can customize this plan as per your need.
Managing Your Emotions During a Downturn in the Equity Market: Having a pre-loaded plan does not mean that it will be easy to execute. The real challenge comes from the psychological mind games a falling market plays on you in stages. It all starts when the market is initially down 15-20%.
Step 1—The Worrying Stage: What if the market falls further? What if current bad news is extrapolated or experts warn that the worst is yet to come? What if everyone is selling out and you’re worried you’re wrong? What if your personal circumstances worsen – job loss, pay cut, health issues, etc.?
Step 2—Before it’s Too Late, Do: There will be pressure to make quick decisions when your portfolio is going down every day. There will be an urge to exit and avoid further losses and you feel that you can enter back at lower levels.
Step 3-Resistance: This is where you let go of your nervousness, remind yourself that no one can time the markets and that tolerating market downturns is an emotional fee paid for long-term equity returns, and ultimately Stick to your plan and belief in me.
step 4-Oops! The market has declined further by 5-10%.
Step 5—’I Know It All Along’: From the back, it would seem clear that this fall was coming – red flags were everywhere and this fall was predictable. Actually, you predicted it a few weeks back. You will ignore all those periods where there were red flags but the market didn’t fall. This is commonly known as the ‘hindsight bias’ or ‘I-know-it-all-along’ syndrome.
Step 6- Regrets: This phase of a falling market is where your intuition comes right in the short term. You’re sorry you didn’t listen to your intuition – ‘I wish I had sold already…’
Step 7- Frustration: In this phase, initially, you will find that the returns of your portfolio are less than the returns offered by Fixed Deposits (FDs). Then all your positive gains disappear and your portfolio value is now reduced by the amount invested. A few months have wiped out many years’ gains from your portfolio and even your SIP (Systematic Investment Plan) returns are disappointing.
Step 8-Doubt Phase: This is the stage where you start to doubt your plan. Should you still believe in equities? What if this plan isn’t working anymore? What if this time it’s different?
After this the first phase comes again and the cycle repeats with every 5-10% increase until you eventually panic and run out of equity. No wonder falling markets are the ultimate behavioral test for investors. Overall, these are three steps that can help you take advantage of a falling market but as the saying goes – it is simple but not easy.
Arun Kumar is Head of Research at FundsIndia.
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