How to protect your investments from market crashes by goal-based investing


Stock markets are prone to downturns.

Not only that, it is difficult to predict when the downturn will occur, how long will it last for and when it has ended. All this is known only in hindsight.

This makes investing in the stock markets, either directly in stocks or indirectly via Equity Mutual Funds, risky. (Debt Mutual Funds on the other hand are not dependent on stock markets and act more like FDs).

A prolonged or severe downturn is called a market crash.

The most recent crash in the Indian stock market history was in 2008 when the markets went down more than 50% during the year.

Like downturns, crashes are also unpredictable. In fact most of the investors and fund managers were highly optimistic about the markets right before it went down in 2008.

Market crashes are an inescapable truth of investing. They have happened in the past and will happen in the future as well.

If you are going to invest in the stock markets (directly or via Equity Mutual Funds) for the long term, one thing you can be sure of is that you (and your investments) are going to witness a few stock market crashes.

If you think you will be able to get out of the market before it crashes you are kidding yourself.

This is what a prominent Indian portfolio manager recently wrote in his blog post:

"Only two people can buy at the bottom and sell at the top – one is God and the other is a liar."

This inevitability of a stock market crash and our inability to predict it is what induces the greatest fear amongst equity investors.

So how can we protect ourselves against something we can't predict and still benefit from it?

Before we get there, there is another question that needs to be examined.


Are all market crashes bad?

Or in other words, can some market crashes be good for you?

Of course whatever investments you have made in the stock markets will go down with the market during the crash. So, on an immediate basis all market crashes will hurt you like hell.

But what about eventually?

Take a look at two hypothetical market scenarios below.

Market-Scenarios

Both scenarios have the same starting and ending points (1000 and 3100 respectively) for the stock market over a time frame of 10 years.

But the paths they take (i.e. the sequence of returns) to get there are different.

In both cases there is a 50% market crash but the timing of the market crash differs.

In the first case, a crash occurs early in the time frame (year 1) and in the second case it occurs late, towards the end of the time frame (year 10).

The CAGR of the stock market is 12% in both cases. (Why? since it just depends on the starting and ending points and the time frame - all of which are the same for both scenarios.)

You are investing Rs 10,000 every month in both scenarios.

Will you end up with the same amount of money in both cases?

In which case will you have more?

...

...

You will have more money in the first case where the crash occurs early. In fact you will have twice as much money in the first case than in the second.

Why?

Because in the first case, your subsequent investments are made at a lower price and hence you are able to get most of your investments in at a lower average price as compared to the second case where your average purchase price is higher even though final price is the same.

Market-Scenarios-with-Average-Price

Here is an even more interesting result - you will have more money in the first case with an early market crash than if the market had not crashed at all!

Market-Scenario-3---No-Crash-2

Table: Comparison of different market scenarios

Scenario Average Price Total Amount Invested Final Investment Value
Scenario 1 - Early Crash 1,727 Rs 12,00,000 Rs 30,67,353
Scenario 2 - Late Crash 3,555 Rs 12,00,000 Rs 14,07,625
Scenario 3 - No Crash 2,050 Rs 12,00,000 Rs 21,36,003

In the good crash scenario you end up with almost 50% more than if there was no crash.

Who would have thought!

This variation is due to the fact that you are continuously adding money at different prices. Hence your returns will depend on not just the starting and ending points (i.e. stock market returns) but also the sequence of returns of the stock market.


Good crash and bad crash

So all market crashes are not the same. Early crashes are good and late crashes are bad.

Early and late get defined vis-a-vis when do you need to take the money out i.e. the time duration of your goal (e.g. for your child's education, or for your retirement)

Early stage crashes are good because:
a) Majority of the investment is still to come in
b) There is enough time for the markets to recover from the crash

Late stage crashes are bad because:
a) Majority of the investment has already come in and suffered a crash
b) There is very little time left for the markets to recover from the crash before you need the money

So we need to protect ourselves from just the bad late stage crashes (and welcome the early stage crashes so that we can benefit from them).


How to protect from the bad crash (and benefit from the good crash)

Step 1. Have a time horizon in mind for your goal.

This will help you differentiate between what is early and what is late so that you don't treat the two stages in the same way.

Many people (especially those who invest in amorphous Wealth goals) take a 'let's see how it goes approach' towards time horizon of their investments.

If it goes well, I will continue, otherwise I will withdraw - which is precisely the wrong approach to take.

A little bit of planning and commitment can go a long way in improving your investment outcomes.

Step 2. Have a higher equity allocation in the early stages.

In the early stages there is enough time to recover from any crash that may occur.

But your equity allocation should also depend on your risk profile. Do not invest more than what your risk profile suggests as otherwise you won't be able to stay the course even during the good crash.

Step 3. Decrease the equity allocation and move to debt in the later stages.

As you approach your goal, there is lesser and lesser time remaining. Start decreasing your equity MF allocation and shift that money to debt MFs where they will be protected from any market downturns while still earning similar to an FD.

This will ensure that you don't suffer a catastrophic loss just when you were about to reach the goal.

For example here is an asset allocation schedule that you can follow for a 10 year goal (with a moderate risk profile):

Year Equity Debt
Year 1 60% 40%
Year 2 60% 40%
Year 3 60% 40%
Year 4 60% 40%
Year 5 60% 40%
Year 6 50% 50%
Year 7 40% 60%
Year 8 30% 70%
Year 9 20% 80%
Year 10 0% 100%

A time based asset allocation schedule like the one above is known as a Glide Path - an critical part of goal based investing.


Risk Profile + Glide Path = Goal based investing = Peace of mind

Investing according to your risk profile ensures that you can stay the course during a good crash and benefit from it while following a glide path of decreasing equity allocation mitigates the impact of a bad crash on your goals.

Together these two are the pillars of a solid goal-based investing process which helps you take the right amount of risk at the right stage.

In short, peace of mind.

At Goalwise, all your life and major purchase goals (i.e. Retirement, Children's education, House etc) come in-built with their own glide paths customized to your risk profile and time duration.

If you have one of these goals, you can check out the glide path for that goal on the Goal Plan page as shown below:

glide-path-children-10-years

You can see how the goal will initially have higher equity allocation (area shaded purple) which will slowly taper down and shift to debt (area shaded orange) with time.

You don't have to implement this manually either.

Every year when you rebalance your goals, we will rebalance them according to the goal's glide path i.e. the rebalancing process not only takes care of moving from old funds to new funds but also moving from equity to debt as per the glide path.

Easy peasy!

P.S. This is what we mean when we say that we are a true goal-based investing platform.



Summary

  1. Stock market crashes are inevitable. Also you can't predict them.

  2. Not all crashes are bad - early crashes can be good crash where as late crashes can be really bad.

  3. You just need to protect yourself from the bad late crashes.

  4. How? By decreasing equity exposure when you are closer to your goal (Glide Path).

  5. Risk Profile + Glide Path = Peace of Mind