So What Should You Do?
Markets are captivating, mysterious and volatile, so how should one deal with it?
When others are losing their heads around you, keep yours steady - Paraphrasing opening line of ‘If by Rudyard Kipling’
Last week we discussed some of the drivers behind the markets recent melt-up from their virus-panicked lows despite considerable economic pain still persisting. The question is: what should you do now?
Will the market continue to go up or will it fall again. Should you invest now or wait for a correction to enter? The answer is that it should not matter.
The market can only go up or down. But predicting that can be hard, because no one knows what the market will do tomorrow, one month or year from now. In ten years, the markets are likely to be up because human productivity is always inching higher but that is also uncertain and it’s not always the case.
The one thing that you can control is your own behavior. Disciplined investing into an investment strategy that suits your return objectives, constraints, preferences and personality is something that is completely within your control.
In this particular letter, we’ll explore a couple of broad investing themes and introduce a simple investment strategy that should help a majority of first time investors.
‘Buy Low, Sell High’
Even a kid will tell you that the way to make money in investing is to buy something at a low price and sell it when it goes higher. Whether it’s stocks or real estate that seems like the thing to do.
You can make a fortune when your estimate of future cash flows differs from others - the current “market view.” If the market has a dim view of a business’s viability, it typically ignores the stock. If you are able to figure out that, perhaps, things are not that bad, and things go on to improve for the business, then you end up making bank when the market comes around to your point of view.
Alternately, you can buy a growing business with the expectation that it will continue to grow and thus the demand to own its stock will grow along with it, pushing its value much higher. If your estimate of higher growth pans out, you win.
These approaches definitely seem like a sure shot way of making money. So why doesn’t everyone do it?
Because you can be wrong, you can be influenced by the noise around you, your own biases or just be unlucky. Even if you get everything right, you can still get the timing wrong.
Also, this requires lot of work, you need to track companies, understand them deeply and continue to track them for changes. Among many other traits, it needs at least a basic understanding of accounting, inclination to read sleep inducing documents and patience. It is not for everyone.
‘Invest Passively’
If you cannot invest the time and effort required to ‘buy low, sell higher’, aka active investing, then the easiest and cheapest alternative is to invest regularly into a fund that tracks the overall market.
There is considerable academic research that says that in an efficient market, it is hard to beat the market’s return because all known information is already priced in resulting in very little advantage for private participants. So, why bother? You can trade away that drudgery of finding investment opportunities for more leisure time. Just buy a slice of the whole market.
Just like how active investing is not for everyone, neither is passive investing.
For one, passive investing means going with the wave, which means if the market falls significantly like it has recently then your portfolio is also down by that much, if you really need the money or get nervous in such situations, then that can be extremely stressful. Active management is better at limiting downside risks.
The other thing is that there is a belief that markets over the long run always trend higher. That’s not always true, in last 20 years most markets have done that but that’s not always the case. Many markets including the US have had long periods of negative returns. By long periods, we mean the highs that Dow Jones touched in 1965 was not surpassed for nearly 30 years. Even in India the 10 year annualised return for Nifty is 7.5% barely beating a fixed deposit, which makes many wonder if it’s worthwhile endeavour at all
Also passive investing requires making an important decision which is choosing the country, index, fund and ETF and these are all active decisions. Unless you buy Vanguard’s Global Equity and Total World Bond funds, you are making an active bet.
Jumping onto the passive bandwagon without understanding index construction, liquidity of both the portfolio holdings and the fund/ETF being purchased, country specific risks (typically driven by its political economy) would be foolhardy. Similar to active investing, passive investing also requires the investor to do some homework!
Static Allocation Strategy
While the active vs. passive debate above can get heated at times, what matters to investors is the ability of their investments to fund their goals. While active investment approaches can produce higher returns compared to the passive approach, there is no guarantee that they will within the investor’s horizon. Most investors cannot remain invested “forever.” So a singular focus on long-run average returns is meaningless. We discussed this problem in our first Free Float - it is entirely possible for investors to end up with negative returns even over 10-year investment horizons.
The real risk is the risk of missing one’s goals. One way to reduce this risk is to allocate between different assets. A simple, low-cost strategy is to allocate 60% of the portfolio to equities and 40% to bonds. This alone reduces your sequence-of-returns risk to a manageable degree.
The second is to split the equity part of the portfolio into large-caps and mid-caps. This way, you reduce the FOMO factor that has a way of knocking most investors off their investment plan.
Here’s how this “30/30/40” strategy performed historically:
A portfolio that chooses not to choose would have given an annualized return of ~8.42% from 2011 through now, while putting the investor through half the drawdowns of an all-equity portfolio.
With these factors in mind, we have setup a low-cost portfolio that most investors who are starting their investment journey can access irrespective of their stock-broker. We call it the Static Allocation portfolio, and it is live on smallcase now.
While we use ETFs for constructing this portfolio, it is by no means purely passive. The asset allocation decision is an active one. And so are the trading decisions made by you, if you choose to follow it. While we have picked the most liquid ETFs in their categories, care must be taken before trading them. To reiterate, the portfolio we have setup is for those investors who are new to markets and are looking for a simple, low-cost option to get started.
Next Week
We mentioned earlier that your investing strategy should not be based on what others are doing but who you are, we’ll dwell on this more.