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What Can Lead The Lead The Next Market Correction
What Can Lead The Lead The Next Market Correction
Let’s break this down mathematically. Two key variables come into play
• Probability of the event
• Impact of the event
And the outcome is: Probability of the event P(Event) multiplied by the expected impact of the event. For example, the
expected impact of COVID on the market is a 40% correction, and its probability in 2019 or any other year could be 0.001%.
So, in normal circumstances, the probable market correction due to the event would be 40% x 0.001% = 0.004%, which is a
very minuscule market correction. That’s why we don’t discuss or concern ourselves with it. However, when the probability
becomes reality, which is 100%, the market corrects by 40%
Humans are expected to be rational, but in reality, we are emotional. We perceive risk emotionally and not mathematically.
One such behavior is that we mostly remember to carry an umbrella during the rainy season but often we go out on a
motorcycle or in a car without a helmet and seat belt.
Then there are high probability but low impact events, just like lower-than-expected rainfall or the outcomes of a union
budget. They are high frequency, mostly discussed, and low impact events. Most of the market outlook discussions revolve
around these topics.
White Oaklead
What can India
thePioneers Equitycorrection?
next significant Portfolio
And what it means for your portfolio.
Looking Beyond Price Correction
For "Low probability - low impact", we don’t have to worry much, like rainfall during winter in one or two places in the
country or India losing a cricket match against Zimbabwe in a friendly series.
So, how do we safeguard against low probability-high impact events? These events can be anything we may not have even
thought of. For example, a rising interest rate in a developed market to tackle inflation. Rising interest rates and lower growth
are the biggest threats to asset prices.
In a rapidly rising interest rate environment, even a cautiously leveraged company may find itself heavily leveraged. Individual
borrowers may find themselves financially squeezed due to higher EMIs and/or prolonged tenure. All of this may cause
demand destruction and ultimately impact asset prices adversely. Here, we are mainly concerned with the magnitude of the
correction, which is a function of the demand destruction caused by the event and the current valuation of the asset class. The
higher the valuation of the asset class, the higher the potential correction, much like an over-inflated balloon bursts louder
than an under-inflated one.
When attempting to predict any event, it's akin to trying to forecast the outcome of a 'coin toss'—deciding, based on that, who
will win the match. The logical approach is to split this problem into two parts: being probabilistic about the event's occurrence
and not deterministic. As for the impact part, in the case of investing, it can be assessed by considering the current valuation
and evaluating how much deterioration the event may bring to the future cash flow of the company.
White Oaklead
What can India
thePioneers Equitycorrection?
next significant Portfolio
And what it means for your portfolio.
Looking Beyond Price Correction
For example, a strategic decision for someone could be a 50% equity and 50% fixed income at the portfolio level. Nobody
could predict COVID-19. However, when the market crashed in March 2020 and equity valuations became cheaper, at that
time, not only rebalancing back to 50% in equity and fixed income, but also adding 10% more to equity tactically (resulting in
60% equity and 40% fixed income) in response to the cheap valuation of equity could be the possible way to optimize.
One practical way to execute this is by investing in mutual funds that invest in various asset classes which rebalance them
periodically based on their valuations, rather than investing in those assets separately and rebalancing them on our own.
This entails operational and taxation challenges. Additionally, one also needs to have technical know-how about assets,
sectors, segments, and securities
A simple yet effective way is to invest a portion of your portfolio into Balanced Hybrid funds. These maintain a 50% Equity
and 50% Bond portfolio and regularly rebalance it within a certain range.
Another option is to invest a portion of the portfolio in Dynamic Asset Allocation Funds, also known as Balanced Advantage
Funds, which invest in both equity and fixed income and tactically adjust the asset allocation based on their valuations.
The third option is Multi Asset Allocation Funds, which add a third asset class like Gold and a fourth sub-asset class like
Foreign Equity. These funds take into account several more dimensions before deciding the final asset allocation and attempt
to optimize the overall portfolio."
To Summarise
To sum up, the first two categories of risks are likely to be more significant than the latter two. Among
these, the first type poses the most substantial threat. Proper asset allocation emerges as the most
potent and reliable solution to effectively address and manage this risk.
Essentially, prioritizing correct asset allocation is crucial in safeguarding against the most pressing risks
and ensuring a more secure financial strategy.
White Oaklead
What can India
thePioneers Equitycorrection?
next significant Portfolio
And what it means for your portfolio.
Looking Beyond Price Correction
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