Fear holds the key

Exit equities if you fear market is rising too fast, or for too long

A reader asked an interesting question: would it be beneficial to exit the market in anticipation of a decline even if the portfolio is created to achieve a long-term goal? In this article, we discuss the benefits and the consequences of moving out of your equity investments in anticipation of a market decline.

Avoiding losses

As humans, losses typically cause twice as much pain as gains give us happiness for the same amount.

That is, losing ₹10,000 will cause you twice as much suffering than gaining ₹10,000 will give you happiness. This suggests that avoiding losses is typically good for your emotional well-being. It is also good for your financial health. How?

Suppose your portfolio, created two years ago to make a down payment for a house in 2028, carries unrealised gains of 20%. Now, suppose the market declines by 25%. Your equity investments have to increase by 33% to recover the unrealised losses.

In addition, these investments would have to earn the expected post-tax return (say 10%) for that year to be on track to meet your goal in 2028. Such returns could be difficult to achieve.

By moving out of equity investments before a market decline, you could avoid large losses. That means you are under no pressure to reinvest any time soon to recover losses, which is good for your emotional and financial health.

Emotional stress

But, that is only one side of the story. When you move from equity and into bank deposits, your portfolio’s expected return falls. Why? Suppose the expected return on equity is 10% and that on bonds is 4%. Assuming your portfolio has 60% allocation to equity, your portfolio’s expected return would fall by 3.6% (that is, 60% of 6%, the return differential between equity and bonds). So, you have to save more every month to bridge this difference.

That is not the only issue! What if the stock market does not decline as anticipated and instead climbs up? At some point in time, you have to reinvest in equity to bridge the return differential mentioned above. But, you could lack the confidence to reinvest, given that your initial decision to exit proved wrong.

Further, what if the market declines after you reinvest? You could suffer a significant emotional stress from another bad decision! In a bid to avoid losses, your decision to move out of equity investments could hurt you!

So, what should you do?

The answer depends on your emotional state because managing personal investments is more than just a financial decision. If you believe that the market has been climbing up for too long, or too fast, and you fear giving up your unrealised gains, then exit your equity investments.

You will suffer from regret if your decision proves wrong. But that is the trade-off for yielding to your fears; for carrying such fears for too long can harm your physical well-being.

Go for SIP

You should reinvest when you believe the market has declined to a reasonable level. It is better to set up a short-term systematic investment plan (SIP), preferably 6-10 months, to average your reinvestment through the ups and downs of the market.

Importantly, as an automatic debit from your bank account into an already-selected equity fund, SIP takes away the need to make a decision each time you reinvest.

Such active distancing substantially reduces your regret from reinvesting. So, to answer the reader’s question: Your fear is the key to exiting your equity investments, and SIP is the process to get back in.

(The author offers training programmes for individuals to manage their personal investments)

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Printable version | Jul 11, 2020 8:29:51 PM |

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