Stomach Churning Volatility : My Constant Companion

I have discussed many times on my blog about my no holds barred approach to EQUITY investments.  As an ERE (Early Retirement Enthusiast) I need to give my networth the best opportunity to increase during the accumulation phase of my working career.  The fervent hope in this asset allocation strategy is that equities are the best way to build up a corpus.

However, there is a high price that comes with a high risk portfolio that is heavily skewed towards equity investments. Obviously it is the highly volatile nature of the stock markets, that cause this risk, and the distinct possibility of suffering significant losses during market downturns. In this post I want to focus on the magnitudes of these swings and what it means to my portfolio in terms of gains and losses. We will use some back tested data, using historical index information

In my A4 Portfolio post, I had shared my asset allocation that is heavily skewed towards EQUITY. Like I showed in that post, my current equity allocation is upwards of 75-80% This is a relatively high proportion for a single asset class, particularly one that is known to have a very high level of volatility.  

In fact, one of my readers had commented the following regarding the high risk involved with this strategy:

Have you stress tested your portfolio? I think it is too aggressive. The early retiree portfolio I know have max, 50-40% equity which is a pretty decent exposure. They decide equity exposure based on how long they can live comfortably with the debt component alone. At such high levels of equity, a poor sequence of returns could prove detrimental.

I provided a short response to this, and other similar comments in a Q&A format titled Good Discussion is Like having Riches. In summary , I do agree that this is a high risk strategy, and may not be suitable for everyone.

The key question though is What is the impact of this risk? How does this manifest and impact my portfolio on a daily basis? To get a good handle on this, lets make some simplifying assumptions and take a look at some data. I will start by assuming that 100% of my portfolio is invested in equity.  In reality I have 75-80% in equity, but since this is such a large percentage, my overall portfolio behaves pretty much in line with the stock market. I will also assume here that the SENSEX is a good representation of the broader stock markets, so we can use the historical data that is easily available for this index.

In the following graph I have shared the SENSEX returns per month for the last 20 years

Now this is a fairly typical plot that you have probably seen multiple times, if you are familiar with the volatile nature of equity markets. On the X-Axis each month is plotted, and on the Y-Axis, the percentage return in that month is shown. For additional clarity, I have shown horizontal marker lines delineating percentage gains/losses of +10%, +20% and -10%, -20%.

First you can see that I had to extend the range upto plus/minus 30% to accommodate 2 particularly volatile months in Oct'2008 when the market plunged ~24% and May'2009 when the market shot up ~28% These extremes are the best indication of the whiplash like swings the market can throw at you.

If you disregard those extremes, the market tends to swing between a relatively more sedate plus/minus 20% as you can see in the picture. Based on the scattering of dots, you can also see that most of the monthly action tends to be within the plus/minus 10% range, with a 14% chance that it will be outside that range. 

This picture clearly establishes in no uncertain terms the quantitative impact of the variation that you can expect to see in a 100% equity portfolio. At 75-80% exposure, the variation will be somewhat lower, but not by much! However, it is not easy to visualize the impact of such high variation simply by looking at the numbers. To better understand and really feel the impact of the volatility you need to think about it in terms of your corpus swinging around like a yo-yo

I had shared in Portfolio Building: My Case study that our retirement corpus is currently at 36X of annual expenses. Let us see how this kind of portfolio would be impacted by the levels of volatility seen in the above picture. We will start by backtesting a 25X portfolio invested 100% in equities (as I pointed out earlier, I am not 100% in equities, but do have a very high exposure to this asset class) Here is how I have put together the following graph. In May'2012 the SENSEX dropped 6.35%, which would have resulted in a corresponding 6.35% drop in my corpus as well.  So a 25X portfolio would be now reduced by 6.35% to 23.4X of annual expenses. 25X annual expenses is equivalent to 300 months worth of expenses. A 6.35% reduction would result in a loss of 19 months of expenses. So a -6.35% downswing amounts to a loss of 19 months worth of future expenses, which is plotted on the Y-axis of the graph.  In essence it is a simple scaling of the Y-axis of the previous graph in terms of the annual expenses

Each horizontal gridline in the above graph represents 12 months worth, or a single years worth of annual expenses. As you can see from the above graph there are quite a few  dots that are outside the plus/minus 24 months range. These would be cases wherein in a single month, my portfolio has gained or lost upwards of 2 years of annual expenses. Beyond the 12 month range there are a large number of dots which denotes the fact that in a single month a 25X portfolio can easily swing by more than a full years worth of annual expenses. 

Considering that in a given month, we typically are able to save approx one months worth of future expenses, you can clearly see that the swings in the market more than dwarf our ability to save and add to our corpus. Our corpus crossed the 25X mark, more than a year ago, so we have been living with these high portfolio swings for a while now.  For example in March'2015, a few months ago, the markets tanked 4.78% resulting in a loss of more than a years worth of expenses that we had saved up.

These kinds of swings are brutal in absolute terms once you have amassed a reasonably large corpus, which will be the case as you near your financial goals if they are being funded by equity.  In my case, since I need to push ahead to upto 50X annual expenses in terms of savings, I need to continue with equity exposure (Read my 50+ Year Retirement Map).  But surely these large swings have tested our nerves in terms of our asset allocation strategy, and the risk we are exposing it to.

There are several methods to reduce the impact of market swings which we will probably consider once we get into our retirement phase.  But for now we are preparing ourselves for a few more years of Gut Wrenching Volatility, wherein the span of a single month, we could lose 3 to 4 years worth of annual expenses that we have worked hard to save up. At a corpus size of 36X annual expenses, a single percentage point swing in the index results in a loss (or gain) of more than 4 months worth of expenses.  Our coping strategy is to ignore daily market movements, and focus on monthly results only. Also we don't look very closely at individual asset performance, and instead focus only on the overall portfolio return, and if it is tracking the index performance, with hopefully higher upside during upswings, and lower downside during downswings. Adjustments are made only if the overall portfolio starts veering off course when compared to the baseline index.

Looking forward to learn from others who have a large corpus invested in the markets and are surviving the extreme volatility that gets thrown their way!

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