The Hindu Business Line : Drawdown minimising strategy

Many investors have suffered about a 50 per cent drawdown in their portfolio value since the market crashed last January. Our interaction with clients and other market participants have shown that the investors who have suffered the least are the ones who were able to control their greed when the market trended up between 2003 and 2007. Here’s a strategy that retail investors can adopt to control their greed and yet build wealth.

House-money effect

Suppose a retail investor has allocated Rs 10 lakh for equity exposure to mid-and small-cap stocks. Further suppose that the retail investor has a risk tolerance of 10 per cent. This means that she is willing to lose not more than Rs 1 lakh of capital due to asset price declines.

Assume that the investor gained Rs 1.5 lakh in the first year of investment. Technically, the portfolio gain is also the investor’s capital. After all, the investor has invested time and effort to pick the stocks and construct the portfolio.

Logically then, the capital-at-risk on the portfolio should be Rs 1.15 lakh, being 10 per cent of Rs 11.5 lakh. This risk measure is important because the investor will have to pick stocks accordingly.

But investors’ perception of risk on capital gains is different from that on initial capital. The initial capital may continue to have a risk tolerance of 10 per cent. The portfolio gains of Rs 1.5 lakh will, however, carry a higher risk tolerance. The reason is because of what behavioural psychologists call as “house-money effect”.

Investors will consider Rs 1.5 lakh as the money that has come from the market, just as a gambler considers his winning coming from the “house” or the casino. This separation of capital triggers an appetite for higher risk that eventually leads to large losses — just as winning at the roulette prompts a gambler to take aggressive bets against the house.

Constant capital-at-risk?

The investor can minimise the house-money effect by taking the gains of Rs 1.5 lakh out of the equity market. She will then be left with only the initial capital with a risk tolerance of 10 per cent. The capital-at-risk will, hence, be a constant.

The portfolio gains so taken out can be invested in bond-like investments. The Post Office Monthly Income Scheme (POMIS) combined with a Post Office Term Deposit could be good choice, as will be a term deposit with a public-sector bank.

It is important to understand that the objective is not to generate above-inflation returns; the above investments will not then serve the purpose. Rather, the objective is to preserve nominal capital borne out of the gains and generate decent returns.

But can investments grow if gains are taken out of the market? The answer lies in the core-satellite approach that this column has long advocated.

The constant capital-at-risk fits well within this framework. The core portfolio is the market (beta) exposure, which will be primarily in index funds or large-cap stocks. Any gains on this portfolio will not be taken out of the market, for two reasons. One, there is limited opportunity to take higher risk on this portfolio, as it will be rebalanced periodically to align with the horizon objectives. And two, taking away profits could lead to shortfall in returns at the horizon, as this is the primary portfolio that strives to achieve the investment objective.

The satellite portfolio strives to generate higher returns (alpha returns) through market timing and exposure to mid-cap and small-cap stocks. It is here that the “house-money effect” will come to play. Investors can, hence, apply the constant capital-at-risk strategy on this portfolio.

Conclusion

The house-money effect can prompt a trading strategy that can be hazardous to investors’ wealth. It would, hence, be optimal to take out profits on the satellite portfolio at periodic intervals and invest the same in bond-like investments.

(The author is an investment strategist. He can be reached at enhancek@gmail.com)

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