On September 21, 2018, an unsettling news flashed on Economic times website –
Rs 5.66 lakh crore investor wealth wiped out in 4 days of market crash.
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However, the news wasn’t all that grim as the Sensex recovered most of its fall by the end of the day. After a flash crash of 1,128 points with a matter of minutes, claimed the ET article, “the 30-share Sensex recovered most of the losses to close at 36,841.60, 279.62 points, or 0.75 percent down.”
It’s not uncommon to find these breaking news on financial media every now and then. It’s become more frequent especially during recent times.
Have you ever asked this question, “Did investors really lose 5.66 lakh crore in a matter of few hours?”
If you were holding the stock of Infosys(INFY) and its price crashed by 30 percent in a day, have you really lost 30 percent of your INFY investment?
Yes. You do. Only if you sell your stock as soon as it crashes. But what if you held onto it for a little longer and it recovered shortly? Like it happened on Sept 21 when the Sensex recovered most of its loss on the same day. In that case, you didn’t really lose the money, did you?
The first thing we need to understand is that unless you sell your stocks or mutual funds, the claimed losses are just notional. Call them paper losses. And the same goes for profits too. If your INFY stock goes up by 30 percent and you don’t sell it then it’s not really cash-in-hand. Right?
So why do investor panic when there’s a news of market correction?
“My stock is down by 30 percent. What if it goes down another 30-40 percent?” That’s the argument that creates fear in most investors.
A stock falls when there are more sellers in the market than buyers. Presence of more sellers in the market indicates that lesser people want to own the stock and more people want to get rid of it. Which means something must be wrong with the business or the company that the stock represents, isn’t it?
That’s a fair argument.
Here’s an interesting exercise for you. Pull out the old newspapers and see how many times a piece of news or a single event permanently damaged the business of a large company? It’s not very common. Most of the times such news is just noise. It temporarily affects the stock price but then people forget about it and the stock recovers.
Of course, the temporary movement in the stock price is very important for day traders and short-term speculators. For these people, the only thing that matters is the price. They give no importance to the fact that a share is a part-ownership in a company. And the health of a company doesn’t fluctuate on a daily basis like its stock price.
If you’re reading this I assume that you’re a long-term investor. A long-term investor is not looking to make a few quick bucks in the stock market and I hope you’re in this game for the longer haul.
For the long-term investors the real risk in the stock market is not the volatility. If the stock you’re holding goes down by few percentage points in the morning and recovers by evening or even in a few days, how does it matter to you?
Risk is a subject that’s widely misunderstood by investors. And one of the reasons is our inability to quantify the risk. It’s very easy to compare investments in terms of returns because returns can be assigned a specific number.
In case of mutual funds, the best we get to know about risk are vague phrases like low risk, high risk, and moderate risk. But what does that mean?
Most MBAs are taught in the business schools that Beta is the measure of risk. For the uninitiated, Beta is the measure of volatility, i.e., a high beta stock is one which fluctuates wildly. But we just saw that volatility in itself isn’t a risk for long-term investors. So beta is pretty much useless in this context.
Warren Buffett, world’s greatest investor has often derided Beta. He says —
The riskiness of an investment is not measured by beta (a Wall Street term encompassing volatility and often used in measuring risk) but rather by the probability — the reasoned probability — of that investment causing its owner a loss of purchasing power over his contemplated holding period. Assets can fluctuate greatly in price and not be risky as long as they are reasonably certain to deliver increased purchasing power over their holding period. And as we will see, a nonfluctuating asset can be laden with risk.
Focusing too much on beta and trying to minimize it can take away our focus from the real risk. And what is the real risk for people like us who invest in Mutual Funds with an intention to hold our investments for a very long time?
In most simple terms, the risk with investing is — not having the money when you need it. So for a short-term speculator, volatility is a risk because in volatile markets there’s a high probability that he will not be able to encash his investments in the short-term.
Imagine you buy a house and give it on rent. The house is an asset for you that produces a consistent cash flow. If you are not planning to sell it in the near future then a temporary slump in the property rates shouldn’t bother you.
The risk, according to Warren Buffet, is permanent loss of capital. What does that mean?
Permanent loss of capital means something happens to your asset which permanently damages its ability to produce cash. For example, your tenant stops paying rent and you lose the court case against him. In that case, your asset (house) is gone permanently.
Similarly, in the case of shares, if the underlying company’s business goes bad which affects its ability to generate profits in the future, then you can say that your asset has gone bad.
For mutual fund investors, that kind of risk is mitigated because mutual funds invest in multiple stocks. So even if few of them go bad, you don’t risk losing all your capital. That’s called diversification.
Apart from diversification, there are few other things that an investor should keep in mind to minimize risk.
As I said earlier, the real risk is not having the money when you need it. And that risk materializes when a money committed for long-term is forcefully withdrawn in short term. In other words, it’s risky for investors to use short-term funds for long-term investments. Short-term money is that money which you might need in the next three to five years. Which means, only that portion of your funds should be deployed in the stock market which you are not going to need in the next five years.
Which brings us to the first rule of personal finance, i.e., having an emergency fund. An emergency fund is a money that you either keep in Fixed Deposits or Liquid Funds. And the thumb rule is to have at least six to eight months of your expenses tucked away in your emergency fund.
The second major source of risk is debt. Investing borrowed money is the extreme case of using short-term money for long-term purpose. Playing with debt is very dangerous. The returns in the stock market are very lumpy. They follow a non-linear path. But your debt repayment schedule will never bother about respecting your investment return schedule. The lenders can come calling at the most inappropriate time.
It’s like playing a card game where you’ve been dealt with a very good hand and you know you’re going to win. But right in the middle of the game, your cards are snatched away from your hands. That’s what happens when you use debt.
So avoiding debt will reduce your risk drastically.
To sum it all up, volatility is not a risk for long-term investors. Diversification, maintaining an emergency fund and avoiding debt will ensure that your risk is minimized.