I wrote the following to my subscribers recently. Hope you find it useful too.
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I am sure some of you got sick of my repeated discussion of risk management last year. In a bull market, the last thing you want to discuss about is risk. If a small cap stock, especially an IPO goes up by 3X in 3 months inspite of having an operating history of just a few years, forgoing such an opportunity to reduce portfolio risk appeared foolish.
This is always the case in bull markets. However, the same people who ignore risk in the stock market, do not behave in a similar fashion in other parts of their life. Have you ever heard someone with auto insurance, regret collecting the assured amount, inspite of paying the premium?
The price of focusing on risk and managing the downside during bull market is paid in the form of forgone returns. One should think of these ālostā returns as an insurance premium you pay for the bear markets.
Ā
Let me explain how
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Let me explain how
Volatility at play
Letās look at two managers who end up generating the same returns over a 5-year period.
Manager A (cautious and nervous)
Year 1 :Ā Ā Ā Ā Ā Ā Ā Ā Ā Ā +20%
Year 2 :Ā Ā Ā Ā Ā Ā Ā Ā Ā Ā +20%
Year 3 :Ā Ā Ā Ā Ā Ā Ā Ā Ā Ā -5%
Year 4 :Ā Ā Ā Ā Ā Ā Ā Ā Ā Ā +23%
Year 5 :Ā Ā Ā Ā Ā Ā Ā Ā Ā Ā +20%
This manager has delivered a CAGR of 15% with low returns in up markets and a lower drop during the bear market.
Manager B (bold and confident)
Year 1 :Ā Ā Ā Ā Ā Ā Ā Ā Ā Ā +50%
Year 2 :Ā Ā Ā Ā Ā Ā Ā Ā Ā Ā +50%
Year 3 :Ā Ā Ā Ā Ā Ā Ā Ā Ā Ā -50%
Year 4 :Ā Ā Ā Ā Ā Ā Ā Ā Ā Ā +40%
Year 5 :Ā Ā Ā Ā Ā Ā Ā Ā Ā Ā +30%
This manager has also delivered a CAGR of around 15% and beats the market by a big margin during up markets, but also get wacked during the downturn.
The reason manager B does well during bull markets, but get hurt during the downturns is often due to a high level of concentration in the portfolio. It is close to impossible to have a highly diversified portfolio of 30+ stocks and deliver a big outperformance.
The price of a concentrated portfolio (and high returns),is the much higher volatility of returns.
The guts to hold
Now, some of you may argue that as the eventual returns are the same, the path to it does not matter. To answer that question, you have to ask yourself ā will you hold on if your entire portfolio dropped by 50% (and not one stock) and what if itās the first year of your investment? More importantly, will you stay with a manager who performed this way?
I can state with a high level of certainty, that almost 99% of investors will dump the manager B and exit if the entire portfolio dropped by 50% or more. It is tough enough to hold based on your own conviction. To trust a person, you do not know personally, with this kind of volatility is close to impossible.
The net result of the above two styles is that manager A will end up delivering a CAGR of 15% for investors whereas those with manager B would end up with a CAGR of around 6% (assume they exit in year 3 and put all that money in FDs).
The above discussion is a mathematical and behavioral reason for my following comment ā āNo point getting rich, if you had a terrifying experience reaching that pointā. The reality is that most folks will throw in the towel in middle of the journey and never get rich by the magic of compounding.
Time to get ready
We started raising the cash levels in the middle of last year as valuations went crazy. Our model portfolio trailed the midcap and small cap indices in the second half of the year
That was the insurance premium we paid to sleep better this year.
Since the start of the year, the two indices are down by 10-15% whereas we are down by much lower. I hope you are holding on and not planning to throw in the towel. I am amused to see a lot of commentators and investors talk of this drop as some major event. It clearly shows they have not followed the market history.
The Indian stock markets, especially the small and mid-cap indices have dropped by this level every few years. The real bear market in this segment is when the index drops by 25%+ and the scary one is if it drops 40%+. Will that happen in 2018? ā I donāt know and have never tried to predict.
What I do know is that on average the companies we hold are doing well and as prices have dropped, the market is presenting an opportunity. By my last count, atleast 6 companies in the model portfolio are below the buy price and can be bought upto the allocations in the model portfolio.
Will the market continue to drop and more stocks drop below our buy price? Will the stocks already on the buy list continue to drop due to which you could have quotational losses (and not real losses) in your portfolio?
To both the questions ā my answer is ā I donāt know and itās quite possible. I personally, donāt worry too much about these drops if the company is expected to do well in the long term.
I have said it in the past and will repeat here again ā I can supply the analysis, but you need to come with the courage, cash and patience. If you have all the three in place, time to get ready and start purchasing slowly for your portfolio.
End note: By the way, Manager A has more career risk and will end up with lesser assets than manager B who can tout his returns during bull markets. However, investors in manager A come out ahead than those with manager B, as some of the investors in the latter case just drop out and never make the stated returns.
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Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions. Please read disclaimer towards the end of blog.
