Your Tolerance for Market Falls Is Probably Not What You Think

Risk Loss Tolerance markets

When markets fall or the economy goes into a recession, you will remain invested. Or better still, you will invest more (buy low philosophy) to ensure great future returns when markets recover.

Right?

That’s the plan?

Great! It is exactly how it should be. And staying invested (and investing more) in the market falls is how you can create a lot of wealth from stock markets.

But it’s easier said than done.

You ‘think’ that you will remain invested or invest more in market falls. But will you actually do it?

That is something that only time will tell.

But I feel that people’s tolerance for market falls is probably not what they think it is. I cannot prove it. But let me show you an example and maybe you will realize it too.

I am simulating a Rs 10,000 SIP in HDFC Equity Fund starting from January 2007.

I have picked this starting point for one reason. The returns just before Jan 2007, i.e. upto Dec 2006 were great and hence would have attracted many new investors into the market.

So these investors would have begun their investment journey having their own ‘easy money’ notions about investing due to (recent) past experience.

Now have a look at what happens to the value of the investments from January 2007 to March 2009:

Value SIP Market Fall

Observations

  • In the 1st year of SIP, the investor would be patting his back that it was the right decision to begin investing. By December 2007, the investment would be up by almost 30%.
  • But then came what we all remember – the great leveller – the crash of 2008-2009.
  • The investor would have continued his SIP of Rs 10,000.
  • By March 2009, his investments would have come down drastically. Value of total investment of Rs 2.7 lac would have been about Rs 1.7 lac. So from highs of around +34% to a gut-wrenching low of -35%.

And this is where I want to stop this simulation.

What happened after this is well known to all. Markets kept moving higher and higher… and higher.

But think about it.

How many people would have got the guts to remain invested after seeing a drop from +35% to -35%. I know many who lost money and exited.

The notion that equity will give high returns no matter what… is not correct. It’s a volatile asset class and will remain so forever. Investors need to realize that these things will happen whether they accept it or not. And when this happens, their tolerance for losses will be tested.

People have different tolerance(s) for big market falls:

  • When they think about market falls
  • And when market falls actually happen 🙂

How people feel about big falls depends almost entirely on what has been happening in the market recently.

Investors who are asked about their tolerance following high past returns are likely to overestimate it, swayed by exuberance. Investors who are asked following low past returns are likely to underestimate it, swayed by fear.

In rising markets, it’s very easy to claim that you will remain invested in big falls. But most people’s tolerance for portfolio falls is not what they think it is.

And just to clarify, it’s not about starting or stopping SIPs to time the market.

SIP is a small amount when compared with a multi-year old portfolio.

Assuming the investor in discussion is not a new one and already holds a Rs 20 lac portfolio at the start (with Rs 10,000 SIP running), here is what he will have to face in 2007-2009:

Mutual Fund Portfolio Fall

After having Rs 20 lac at the start with Rs 2.7 lac in fresh investments, it is not easy to see your portfolio go down to Rs 14.8 lac. And notice the fall from Rs 32 lac (in Jan-2008) to Rs 14.8 lac in March 2009.

This investor would be less worried about starting or stopping SIPs and more about containing the fall of his multi-lac portfolio that he had already built.

I don’t want to scare you.

For most common people, SIP in equity mutual funds is the best approach to benefit from stock markets.

My only aim with this post was to highlight that you need to accept losses ‘too’ when doing your SIPs. It cannot be one way up. Equity is not a bank FD.

So think about it.

Is your tolerance for market falls and losses really what you think it is? If not, teach yourself to overcome the fear when things really do get bad.

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