The recent stock market crash has presumably affected your financial health. Yet, you take comfort from the typical advice that equity generates positive returns in the ‘long term.’ It is important that you make optimal decisions while managing your personal investments.
To make such decisions, you should first ask the right questions. One such question is: can I achieve my goal if equity generates positive returns in the ‘long term’?
Life’s asymmetry
If you run 10 km every day, you could, perhaps, maintain your body weight or, at best, reduce your weight by, say, 5 kg. But stop running for two months and you would gain 10 kg. Notice the adverse relationship. You do not lose much weight when you run, but you gain more weight when you stop running. In other words, you have to apply more effort to achieve a positive outcome, but a negative outcome comes easily.
A similar relationship exists in the market. Suppose your equity investments declined from 100 to 75 during the recent market crash. Note that a 25% unrealised loss requires a 33% gain to recover the losses (25 upon 75). In addition, your investment has to generate positive returns to justify your decision to buy equity instead of investing in bank deposits.
You may argue that the market can gain 33% just as easily as it lost 25%. That is not necessarily true. Fear is at least twice as powerful as greed. This means that it takes less time for the market to decline than it takes for it to go up. Remember, the market rose between April 2003 and January 2008, but lost 65% in the subsequent 10 months.
Thereafter, it took another two years to recover the losses and an additional five years to generate significant positive returns. So, the question is: Can you wait enough for your loss-making equity investments to generate positive returns?
Goal-based investments
Suppose you created a portfolio in 2010 to fund your child’s college education in 2024. What if your equity investments are down 25% in 2020? Your portfolio has to recover 33% in the next 4 years and, in addition, earn the annual expected return. Why?
Suppose you invested a fixed amount every month from 2010.
You had determined that 8.5% compounded annual post-tax returns over 14 years will help you accumulate the money required to fund your child’s education. Based on a post-tax expected return of 10.8% (12% less 10% capital gains tax) on equity and 4.5% on bonds, you invested 65% in equity and 35% in bonds.
Then, the market crashes four years before your child is scheduled to go to college. What should you do? You cannot wait for the ‘long term’ because you need the money four years hence. Besides, you need to earn 10.8% returns every year on your equity investments to achieve your goal.
The point is this: Equity investments could recover over a long term. But you have a different time horizon. So, the question you should be asking is: are your investments likely to recover losses and generate gains in time to fund your life goal?
Thinking of equity as a long-term investment can help you reduce the emotional pain of investment losses. But that is unlikely to help you achieve your goal. What should you do?
For one, you should continually reduce your portfolio’s equity allocation as you come closer to the time you need the money for your life goal. For another, you should have a plan to bridge any shortfall in your portfolio to meet your life goal.
(The author offers training programmes for individuals to manage personal investments)