Significant market corrections and the ripple effect on your portfolio

Investors always worry about the next major market correction and what could trigger it. While we often contemplate risks tied to specific events that could lead to a significant market downturn, the truth is that the events capable of causing such a correction are largely unknown. The worldwide crisis and the aftermath of covid-19 pandemic was surely never on the radar. The rationale for this: it was a low-probability event with high short-term impact. Conversely, the much-anticipated risks are usually high-probability events with lower impact.

Mathematically, the probability of an event and the impact of the event are two key variables that lead the total impact. For example, the 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 is impact of covid multiplied by the probability of covid, which is 40% x 0.001%, and this equals 0.004%, which is a very minuscule market correction. That’s why we don’t discuss or concern ourselves with it. But when the probability becomes reality, which is 100%, the market corrects by 40%.

There are four probable scenarios that play a major role in market correction. First is ‘low probability-high impact’ event. Imagine someone playing Russian roulette with a pistol having 10,000 chambers and just one bullet. The outcome is a low probability but a very high impact intrusive event. Then comes ‘high probability-low impact’ events, just like lower-than-expected rainfall. They are high frequency, mostly discussed, and benign events. Most of the market outlook discussions revolve around these topics. Another scenario is the ‘low probability-low impact’ events that aren’t worrisome, like rainfall during winter in a small part of the country or India losing a cricket match against Zimbabwe in a friendly series. Last in the list is ‘high probability, high impact’ event. These events are generally rare, because for such high probable events, we would have already built safety nets and checklists to steer clear off.

Safeguard against low probability-high impact events

Rising interest rates in a developed market to tackle inflation is one such example and one of 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 equated monthly instalments and prolonged tenure. Thus, it causes demand destruction and ultimately impacts asset prices adversely.

Whilst predicting 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 and not deterministic about the event’s occurrence. As for the impact part, investing 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.

What should one do? We cannot predict the event nor control the outcome. However, as investors, what we can control is our own asset allocation.

Strategic and tactical asset allocation could help. For example, a strategic decision for someone could be a 50% equity and 50% fixed income at the portfolio level. Nobody could predict covid. However, when the market crashed in March 2020 and equity valuations became cheaper, the response at that time should have been to 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).

One practical way to execute this is by investing in mutual funds that invest in various asset classes which is rebalanced 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 the technical know-how.

A simple yet effective way is to invest a portion of your portfolio in 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.

Chirag Patel is co-head–poduct strategy, WhiteOak Capital AMC.