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To embrace risk or avoid it?

by Money Puzzle   ·  April 10, 2020   ·  

To embrace risk or avoid it?

by Money Puzzle   ·  April 10, 2020   ·  

The argument that the spread of COVID-19 was a given and more should have been done sooner, is not a strong one in my opinion. How much earlier is sooner? Moreover, scientists and doctors understood the asymptomatic nature of the infection only once it had passed on beyond the original epicentre. The fact is that the appropriate response to a pandemic can happen only once it is a pandemic. Every previous epidemic/pandemic then becomes a learning experience to tackle the next one.

This is apparent from South East Asia’s quick and comprehensive response to curb the spread of this virus.

They also only reacted only after infected people unwittingly (or foolishly) started carrying the virus out of China, but be it quick and widespread testing, timely shutting down of non-essential services, breaking of school sessions, travel bans or extreme focus on masks and hygiene – all steps were taken with due process, in a calm and logical manner.

Take Taiwan for example, a high-risk location thanks to its physical proximity to the epicentre of this virus outbreak and some of the early affected regions. However, it has one of the lowest infection rates at around 373 cases with 5 deaths as reported by Taiwan Centre of Disease Control. Experts are citing this ability to manage the crisis to a measured and systematic response rather than a particularly early or war-like response.

Why am I talking about this in a blog that is published on a personal finance website? Because whether you like it or not, risk is part of our daily lives.
Every day you and I take risks, some big some small. The pandemic is a huge risk in our lives. It is in our response to this risk that we will define the outcome.

Just as it has happened with the infection, it is important to accurately understand your own portfolio risk, then apply the appropriate response to it.

Facing your portfolio risk

Over the last two years at least 90 lakh new demat accounts have been added to the basket of equity investors, bringing the total number of demat accounts to roughly 4 crores. At the same time as on December 2019, total investor accounts or folios in asset management companies increased from roughly 6.7 crores two years ago to 8.7 crores; equity-oriented schemes account for roughly 72% of mutual fund investor accounts.

The growth in demat accounts, along with a necessity for investing in equity shares, coupled with the rising popularity of equity-oriented mutual funds shows that the individual investor is increasingly investing for long term wealth creation through equity assets.

Despite this thumbs up to equity, financial planners and advisors continue to deal with the quandary of individual investors aggressively adding to equity risk but unwilling to embrace it when it does not play out.

If you have been investing in equity for the last year or two, and are now spooked by the sharp fall, all too ready to withdraw your investment, then ask yourself two questions. Firstly, do you really understand equity risk, to begin with, and secondly, is an aggressive panic reaction right now going to help you or should you adopt a more systematic, logical and calm approach?

By withdrawing your equity investment today and waiting for markets to rebound before you re-enter, is a bit like sitting at home during the COVID crisis thinking it will make the virus go away. You are in a lockdown not because the virus will vanish when you emerge from it, but rather to help minimise the initial rapid spread of infection to ease the burden on the country’s medical infrastructure. At some point, you will have to step out of your homes, face the situation by ensuring stringent precautions till the spread of infection lowers or a medicinal solution is discovered.

Understanding equity risk

Just as it’s important not to misinterpret the reasoning behind the lockdown and the expected outcome, one has to understand what equity risk is about.

In a short explanation, equity risk equals the risk of capital loss. As you know now, you can lose a phenomenal amount of capital or have your gains wiped out very quickly when the environment turns bad. This is essentially price volatility. Hence, along with the ability to create wealth, equity assets can eat into returns as well.

Let’s put this in some context. Over the last 30 years, the Nifty 50 Index (referred to as the ‘market’) has given an annualised 12% return. During this period there have been 6-7 times when the markets corrected between 30%-50% (or more). Once this happened over 2 years, once in 10 months and once in 2 months. It is very hard to predict when and how far equity prices can fall or go up in the very near to medium period of time – say 1 month to 2 years. Anything can happen. But this anything does not take away from equity asset’s ability to give you above-inflation returns over longer periods.

To withdraw now from equity in a bid to avoid risk is sealing in the loss and letting go of any chance at recovery in capital or in the shaved off gains.

The real risk of redeeming now is that you will not be able to meet your expected return – pencilled in for either your retirement or your dream house or whatever else it is that you were creating wealth for. Plus, the risk will not go away just because you withdraw; you have to instead ride it out, with adequate precautions and wait for things to get better.

Past experience shows us that over longer periods, equity risk smoothens out. A sharp fall will make your long-term returns look bad, but wait for recovery, all those accumulated gains can show up again. In the meantime, focus on your goals and always on the quality of securities you hold – be it mutual funds or direct stocks.

The cashflow risk

We should also address matters of cashflow. As a result of the lockdown and pausing of commercial and manufacturing activity, there are going to be job losses and pay cuts. There is a possibility, you may not be earning as much as you expected for this year. If you find you are falling short of some essential cash requirement like loan repayments or your rent, then dip into savings in fixed deposits and other fixed-income linked investments first. If you are falling short of the money required for something essential, like your child’s college expenditure coming up in six months or a medical emergency you hadn’t catered for, then withdraw from equity as a last resort. If you have adequate cashflow to manage expenses and no goal coming up, embrace equity risk to do justice to your long-term return expectation.

Take a break and watch this video now.

How Financial Planning manages risk

I began this blog by talking about a much greater risk – widespread infection – faced by all of us. As the days go by, despite the relatively lower infection spread, avoiding this risk altogether doesn’t seem possible. Instead of acting out in fear and remaining locked in for several more months, we may have to embrace precautions with a tenacity that matches what’s seen in countries such as Taiwan, Japan and South Korea where moving about in public without a face mask can lead to fines.

The learning if anything from this outbreak of coronavirus, is the need to embrace precaution more seriously because the alternative (ie. severe lockdowns) is simply not sustainable for long periods.

This question of whether to embrace or avoid risk in equities has a similar outcome. Can you afford to lead your life and hope to grow your wealth without equity risk? Not really. Now that small savings returns too have been lowered and bank rates are headed lower (SBI Savings account rate is now 2.75%!), post tax returns from fixed income are unlikely to cover even the basic annual inflation in the economy.

If you hope to accumulate wealth that will help you in your retirement or help you with the large expenses coming up in your life, you have to take on equity risk. Can you be choosy about when you take on equity risk and when you can avoid it? Not really. You can do that only in hindsight when you have already seen the bottom and the peak. Before it happens, you are unlikely to know that it is going to happen. Just like a reaction to the pandemic, that actually requires the pandemic to happen. You can’t really avoid it.

The real question is are you prepared? Here is where a financial plan will help you the most.

One financial planning rule is to have a 7-10 year head start on large expenditures (financial goal) for which we require equity allocation. Closer to the goal being manifested, you must de-risk by switching that allocation from equity assets (remember short term volatility?) to fixed return investments, thus, securing what you need. Ideally, it can be done 18-24 months before the goal. If you had done that, then the current meltdown in equity assets wouldn’t be alarming. Even if you are late to the party, and say, have just five years to your goal, withdraw and reallocate away from equity with at least 12 months to spare. This way you don’t compromise on that all-important financial goal.

It may be that this is the time you had to make that switch to more stable assets from equity and you find yourself in the midst of this correction. You still have about 2 years to the goal, if you can then stretch your threshold to switch away from equity for another 6 months and then and then some more, till the tide turns. For someone who already had a plan, this is probably the worst-case scenario. Nevertheless, because you saved and accumulated money for 5-7-10 years, you will be able to go ahead with the goal, albeit, you are left with less than expected going forward.

But if you didn’t have a plan, you didn’t have a systematic asset allocation, you didn’t follow any dos and don’ts of financial planning you are possibly looking at a big gap, scratching out some goals altogether.

Just like, wearing a face mask without the understanding that reusing it causes you more harm than good, saving without a plan and avoiding equity risk out of fear is detrimental to your financial future.

Risk is not a bad thing, at times embracing it is the only solution; it is how you approach and manage it which will define the outcome.

Be smart. Be safe. Be invested.

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