How to deal with good and bad market phases?

This article was originally published in Financial Express. Click here to read it.

The recent rally in Indian equity markets also creates an inevitable uncomfortable question—“What if markets fall? Is there anything I should do?”

Here is a simple approach to deal with this dilemma:

Setting the right expectations

When we studied the past 40+ years of market history, Indian equity markets have had 10-20% temporary declines almost every year. It has also experienced steeper declines of 30-60% once every 7-10 years. Using history as a rough guide, here is how you can set the right expectations for your portfolio.

Normal expectation: Expect 10-20% temporary corrections every year; when you check your portfolio, assume 80% of your equity portfolio value and add that to your debt portion’s value. Mentally benchmark the value of your overall portfolio to this number. As long as your portfolio value is above this number, it is behaving exactly as it should. This is the normal expected behaviour from your portfolio. This way, you will be able to put the common yearly temporary declines into proper perspective and won’t be surprised by them.

Unusual expectation: Expect 30-60% temporary corrections once every 7-10 years. While these large corrections are not frequent, history shows that it’s reasonable to expect a large fall every 7-10 years. It is very difficult to predict ‘when’ these large falls happen and which 10-20% decline converts into the big one. So, when you check your portfolio, also assume 50% of your equity portfolio value and add that to your debt portion. You should be mentally prepared to temporarily accept this assumed total portfolio value in the event of a sudden market decline. While these large falls are not frequent, this must be a part of the expectation. If both the above assumptions seem too difficult for you to manage, it means your portfolio has much higher equity exposure than your ability to tolerate painful declines. You will need to revisit your original asset allocation (read as the split between equity and debt in your portfolio). Once you are sure that the allocation is in line with your ability to tolerate declines, here is the next step.

Current plan of action

As equity markets have had significant returns in the recent past, there is a high likelihood that your equity exposure has exceeded your original planned asset allocation levels by more than 5%. If yes, this is a good time to rebalance and reduce the equity exposure back to your original planned exposure. The next step is to prepare for different future scenarios.

Preparing for different scenarios

Scenario 1: Equity markets go up around 0-20% during the next one year—this is the baseline expectation from equity markets as it is a growing asset class. Since returns are positive and as per expectation, no action is required. You can continue with your original asset allocation plan.

Scenario 2: Equity markets decline around 0-20% during the next one year—as seen from the past, it is normal for equity markets to have temporary declines of 0-20% almost every year. So, this expectation is a part of the original asset allocation decision, and no action is required.

Scenario 3: Equity markets are in a crisis and declines more than 20% during the next one year—this usually indicates a bear market and although they look scary while experiencing them, these are usually the best buying opportunities in retrospect. You can plan to rebalance back to your original asset allocation by selling debt and increasing equity at intervals of, say, every 10% fall.

Scenario 4: Equity markets rally and go up more than 20% over the next one year—this is a sharp up move and may lead to equity exposure that is higher than the original planned allocation level. This can be a good time for rebalancing—by reducing equity back to its original asset allocation and moving it into debt.

Parting thoughts

Trying to predict the direction of the equity markets consistently over the short term is a very difficult task and history shows us that no one has been successful in doing this. A better approach is to shift from the ‘prediction’ approach to a ‘preparation’ approach. The simple idea is to set the right expectations on what will be considered to be normal vs abnormal using history as a guide. Once this is done, put in place a pre-planned action plan, thinking through different possible future scenarios. This way, you will be able to manage your portfolios across both good and bad market phases without getting overly aggressive or panicked. Overall, this ensures that you are able to stick to your plan and have a good investment experience over the long term.