Ouch! That hurt!

Most of us who have invested in securities (stocks, bonds) this year have seen deep red splashed all over our portfolios. It’s been one harrowing ride after another, all this year. This, after a fantastic 2017, where the markets went only in one direction, that is up. Investors grew very complacent after they were lulled into seeing day after day of low volatility, with markets globally trudging ever higher. Almost everything went up, not just stocks… bonds, bitcoin… you name it. Even stuff like “Tulip Coin” and “Dogecoin”, were able to skyrocket in value. The Tulip Coin was literally referring to the Dutch Tulip mania and the Dogecoin was a joke currency based on Shiba Inu from the “Doge” Internet meme. Talk about irrational exuberance!… The saying “a rising tide lifts all boats” couldn’t have been any truer.

2018 has been a whole new ball game. Volatility is back with a vengeance. The indices have been whipsawing violently with a +/- 2-3% gyration almost on a daily basis. Most of the major world indices are in bear market territory (-20% from the top). The crypto currency space has bitten dust as I predicted. Bonds are threatening to go into a protracted bear market after 3 decades of bull run. The adage “all good things come to an end” has proven itself to be true again in 2018. What should one do in such a scenario? Ordinarily, I would have said “nothing … just stick to your investment plan through thick and thin” and this is exactly what I am doing. But I think there is a more fundamental issue to be addressed before I just say “stick to the plan”. I think the key issue here is the “plan”, which in my case means the asset allocation plan. Let me explain…

Over the past year, I have been helping out a few individual investors to come up with an asset allocation plan. When I asked, before I started with the plan, almost everyone said they were very risk tolerant and wouldn’t lose sleep even if the losses were up to 50% of their portfolio value. I took their word for it and derived an aggressive stock heavy asset allocation plan. Now that they are seeing real losses, not 50% but just 5%, they are losing sleep and want to change the strategy to a more conservative one. I learnt a valuable lesson, never ask people how much risk they can take, as it would be very difficult for them to quantify, especially given that there hasn’t been a real bear market since 2012-13, in India, and most individual investors have pumped in huge amounts of money into the stock market only in the past couple of years. They simply don’t know what it feels like to see their portfolio suffer 20-25% loss in value.

Where there is a lack of experience, people tend to overestimate their ability to endure pain. This has a real base in psychology as well – the Dunning–Kruger effect is a cognitive bias in which people of low ability have illusory superiority and mistakenly assess their cognitive ability as greater than it actually is. I think this same effect is applicable to risk taking ability as well. People without actual experience tend to say that they have more risk taking ability than they actually do. Only when they are really hurt do they realize how much risk they can actually take.

Given this, when one starts investing, how does one arrive at one’s real risk appetite? Especially if one hasn’t suffered painful losses before? The only alternative I can think of is based on an honest appraisal of one’s risk appetite with the aid of risk attitude assessment models. The “Assess your attitude to investment risk” is an assessment model developed by Oxford Risk, an independent team of leading psychology academics originating from Oxford University. There are many such models available on the internet.

So, to every Investor, even before attempting to create an investment plan, please do asses your ability to take risk and use that as an input to derive your asset allocation plan. Things also change as time passes by, so, do assess your risk appetite once in 5 years and course correct your asset allocation plan accordingly.

I would like to end this topic by reciting an incident out of J.P. Morgan’s life, as it relates to seeing losses in one’s portfolio. When a friend complained, to Morgan, of restless nights, worried about his stock holdings, Morgan’s advice was to “sell down to the sleeping point.” This is very sage advice.

Lastly, I’d be remiss if I didn’t say “do nothing … just stick to your investment plan through thick and thin”… you’ll come out fine on the other side. Also remember, don’t bet on individual stocks, finding winners would be like looking for a needle in the haystack. It’s better to buy the whole haystack, i.e. the market, you are bound to have many needles in it. Also diversify geographically if possible.

With that said, I wish all my readers a very happy new year, may your investments touch new highs in 2019.