If you are a young investor, volatility is your friend

If you are new to equity markets, you may have some discomfort with volatility. If you are closer to retirement or you are making a lumpsum investment, this discomfort is quite justified too. You can lose a lot of money and put your financial well-being in danger.

However, if you are a young investor, volatility should not concern you too much. Let’s understand why.

Let’s say you land up your first job at the age of 23 and you can invest Rs 5,000 per month. Every year, you increase the monthly investment amount by 5%. By the way, it is not always easy to invest Rs 5,000 from your first salary because many non-discretionary expenses may not leave you with much. But let’s play along.

Let’s assume you earn a constant return of 8% on your portfolio.

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What does this table show?

When
you are a new investor, bulk of the increase in portfolio size is due to fresh
investments. The returns on your portfolio do not add significantly to your
portfolio.
As you move
closer to the retirement, your portfolio becomes bigger and fresh investments are
only a small portion. At such times, you need to take greater care of
accumulated wealth.

You started with Rs 5,000 per month, increased investment by 5% per annum and ended with Rs 2.55 crores. This shows that you can start small and still accumulate great wealth (at least in nominal terms) if you stick with the investment discipline.

What about volatility? In the above example, we considered an investment with consistent 8% returns and no volatility.

But, aren’t we trying to establish something else?

The concern that we are trying to address is volatility. Equity returns are volatile and it is not fair to expect equity markets to deliver 8% year after year.

Let’s now look at a a volatile investment.

Let’s look at an alternate sequence of returns. You have the same 38 years of working life in the example discussed above. 

You earn -5% p.a. for the first years. Then you earn 22.78% for the next 5. This goes on for the first 30 years. For the last 8 years, you earn a return of 8%. With this sequence of returns, the CAGR is 8% p.a. (same as in the previous illustration).

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As you can see from the table, a major portion of the increase in the portfolio size comes from the fresh investments that you make during the year. If you were to have a down year, these percentages will only grow. As a young investor in the accumulation phase, you shouldn’t worry much about volatility or even bear markets (easier said than done). Volatility can be your friend during accumulation phase.

Rather than getting scared if the markets don’t do well in your initial years of investments, you should be happy that you are getting to accumulate units (ownership) at a lower price. When the good times come, you will get greater bang for the buck since you accumulate units or shares at a lower price.

With this sequence of returns, you will retire with a portfolio of Rs 3.45 crores. In the constant return (no volatility) example, you ended up with Rs 2.55 crores.

I concede I have chosen the sequence of returns to suit my argument. With a different sequence, the returns can be completely different. However, my intent is to show that even when you start with a bad sequence of returns, you can still end up with a higher corpus. In fact, it is these bad returns that result in a bigger corpus. The premise is that long term CAGR is intact at 8%.

Read: What is the difference between CAGR and IRR?

You can end up with a bigger corpus even with a lower CAGR

Let’s
now work with a lower CAGR of 7%. You earn -5% p.a. for the first years. Then
you earn 20.52% for the next 5. This goes on for the first 30 years. For the last
8 years, you earn a return of 7%. With this sequence of returns, the CAGR is 7%
p.a. (as discussed in the previous example).

In this case, you retire with Rs 2.73 crores (higher than Rs 2.55 crores with constant returns of 8% p.a.).

Again, this shows how volatility has helped you. You ended up a higher corpus despite a lower investment CAGR.

Additional Points

There are
behavioural aspects to worry about too.

For
a small portfolio size, the absolute impact of good or bad returns is also
small. For instance, the difference between year end balance for -10% p.a. and
+10% p.a. on Rs 1 lac portfolio is only Rs 20,000. It is Rs 20 lacs for a Rs 1
crore portfolio.

Moreover, if your portfolio size is Rs 1 lacs and you are investing Rs 60,000 per annum, you will end the year with Rs 1.5 lacs even with 10% fall (with the added benefit of accumulating units at a lower price). 1 lacs -10% of Rs 1 lac + 60,000 = Rs 1.5 lacs

However, the same Rs 60,000 per annum is small change for Rs 1 crore portfolio. You will still end the year in red at Rs 90.4 lacs. Your portfolio can go up or down by more than Rs 60,000 (your annual investment) in a day.

Poor returns from volatile assets (say equity) can be damaging when you are about to retire or in early years of your retirement. To put it another way, poor returns can cause a very big problem when you are about to enter decumulation phase or have entered decumulation phase (drawing from your portfolio to meet expenses). By the way, poor returns are damaging during any part of retirement but the damage is much bigger if your portfolio sees big drawdowns during early part of retirement. I have covered this aspect in detail in this post.

Read: Financial Planning for Retirement Vs. Financial Planning during Retirement

Read: What do you worry more about? Your existing corpus or your next SIP installment

Any tips for Young Investors?

#1 For your short-term goals and emergencies, keep money in fixed deposits or debt mutual funds.

#2 For long term goals such as retirement, work with an asset allocation approach. While there are many suggestions about the right asset allocation for you, a 50:50 equity:debt allocation sounds like a very healthy compromise. For now, I am not getting into gold, real estate or foreign equities as part of asset allocation. Check this post on How to build a long term portfolio.

#3 Asset allocation decision is super critical because you are not sure of your risk tolerance to begin with. My experience suggests that everybody is extremely risk tolerant during bull markets. And exactly the reverse during bear markets. Hence, risk appetite can also be dynamic. Most investors don’t figure their real tolerance out until they go through a severe market downturn with a significant amount of capital invested. Therefore, don’t dive headlong into risky assets. Heavy portfolio losses in the initial years can scar you and keep you away from equities for a long period. This won’t be good and you won’t get the benefit of rupee cost averaging during the accumulation phase.

#4 Keep things simple. In investing, simple beats complex most of the time. Pick up an index fund or an ETF and start investing regularly (through SIP or otherwise). If you prefer actively managed funds, pick up no more than 2 actively managed equity funds.

#5 Keep your head down and keep investing. Do not worry about volatility and severe downturn. Just keep investing every month. Remember, during accumulation phase, volatility can be your friend. You just need to get comfortable with it.

#6 Rebalance portfolio at regular intervals. Again, the “right interval” is tricky to arrive at. Think you can give yourself a long rope. Keep tax aspects and exit penalties in mind while rebalancing. Once a year seems just fine.

#7 Focus on earning more. Your time is better utilized acquiring new skills than figuring out the best mutual fund for you. Better skills can help you earn more and increase your potential to invest. Finding the best mutual fund is a never-ending exercise since the baton keeps on passing. Moreover, since your investment portfolio is small at this stage, your energy is better spent elsewhere.

Read: Four phases of Retirement Planning: Earn, Save, Grow and Preserve

The post was first published in February 2019.

Image Credit: Unsplash

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