How to deal with bad and good market phases?

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The recent surge in Indian equity markets raises the obvious uneasy question, “What if markets fall? Is there anything else I should be doing?”

Here’s a straightforward solution to this quandary:

Setting realistic expectations

When we examined the past 40+ years of market history, we discovered that Indian equity markets experienced 10-20% transitory dips virtually every year. It also witnessed higher drops of 30-60% every 7-10 years. Here’s how you may set the correct expectations for your portfolio using history as a guide.

1. Typical expectation:

Expect 10-20% annual temporary corrections; when reviewing your portfolio, assume 80% of your stock portfolio value and add it to the value of your loan component. Mentally compare the worth of your entire portfolio to this figure. As long as your portfolio worth is more than this figure, it is acting normally. This is the typical behaviour of your portfolio. This way, you’ll be able to put the regular yearly transitory declines into context and avoid being surprised by them.

2. Unusual expectation:

Expect temporary corrections of 30-60% every 7-10 years. While major corrections are not common, history shows that a large decline every 7-10 years is reasonable. It is quite difficult to forecast ‘when’ these massive drops will occur and which 10-20% drop would lead to the big one. So, when you review your portfolio, add 50% of the value of your equity portfolio to your debt component. In the event of a sudden market drop, you should mentally ready to temporarily accept this estimated entire portfolio value. While these massive falls are not common, they must be expected. If both of the preceding assumptions appear to be too difficult for you to handle, your portfolio has far more equity exposure than your ability to bear unpleasant declines. You must reconsider your initial asset allocation (read as the split between equity and debt in your portfolio). The next stage is to ensure that the allocation is consistent with your ability to endure declines.

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 rise by 0-20% over the next year—this is the baseline forecast for equity markets because they are a growing asset class. No intervention is necessary because the returns are favourable and as expected. You can stick to your previous asset allocation strategy.

Scenario 2: Equity markets fall by 0-20% during the next year—as witnessed in the past, equity markets experience brief drops of 0-20% practically every year. As a result, this assumption was built into the initial asset allocation decision, and no action is necessary.

Scenario 3: Equity markets are in a crisis and fall more than 20% in the next year—this normally signifies a bear market, and while it may appear frightening at the time, these are frequently the best purchasing opportunities in retrospect. You can rebalance back to your original asset allocation by selling debt and increasing equities at 10% falls, for example.

Scenario 4: Equity markets surge and rise more than 20% in the next year—this is a significant increase and may result in equity exposure that exceeds the original planned allocation level. This can be an excellent moment to rebalance by returning equities to its original asset allocation and shifting it into debt.

Final thoughts

Trying to anticipate the direction of the equities markets consistently over the near term is a challenging task, and no one has been successful in doing so throughout history. A better approach is to move away from prediction and toward preparation. Using history as a reference, the simple concept is to build the proper expectations on what would be regarded normal vs atypical. After that, create a pre-planned action plan by considering several probable future scenarios. This allows you to manage your portfolios through both good and bad market cycles without becoming unduly aggressive or panicky. Overall, this ensures that you are able to stick to your plan and have a good investment experience over the long term.

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