How to Safeguard Your Investments to Survive Market Downturns

Investing is a popular way to grow wealth over time. However, even the most successful investors can experience periods of decline, known as drawdowns. Understanding drawdowns is essential for making informed investment decisions and maintaining a long-term perspective. In this blog post, we'll delve into what drawdowns are, why they occur, and how you can manage them to safeguard your investments.

What is a Drawdown?

A drawdown in the context of equity markets refers to the decline from a markets all time high to its lowest point during a specific period. It is usually expressed as a percentage. For example, if a Nifty Index value drops from 23500 to 21500, the drawdown is 8.5%. Drawdowns are an important measure of risk because they show how much an investment can lose in value during market downturns.

In recent years, the average drawdowns in markets have shown a notable decline, thanks to global liquidity pump post Covid. Historical data indicates that while earlier decades saw drawdowns averaging around 25-40%, more recent periods have experienced average drawdowns closer to 15-25%. Additionally, the duration of these drawdown periods has also reduced significantly. In the past, it was not uncommon for drawdown periods to last several years; however, modern financial markets have seen recovery times shorten to just a few months in many cases.

Post GFC in 2008, Nifty as well as broad markets took "6 years" to break previous highs. However, learning from mistakes of 2008, central banks pumped liquidity across the globe and during Covid-19 crisis, markets saw a sharp recovery and crossed previous high in just "10 months".

(Investors should overcome Recency Bias and manage their expectations basis long term market trends.)

Why Do Drawdowns Happen?

Several factors can contribute to drawdowns, including:

Market Volatility: Stock markets are inherently volatile, and mutual funds, which invest in stocks, are subject to these fluctuations. Market corrections and bear markets can lead to significant drawdowns.

Economic Downturns: Economic recessions, geopolitical events, and changes in government policies can negatively impact the stock market and, consequently, mutual funds.

Sector-Specific Issues: Mutual funds focused on specific sectors (like technology or healthcare) can experience drawdowns if those sectors face challenges.

The Impact of Drawdowns on Your Investments

Understanding the impact of drawdowns is crucial for investors. During a drawdown, your investment's value decreases, which can be concerning, especially if you are close to your financial goals or retirement. However, it’s important to remember that drawdowns are a normal part of investing and that markets typically recover over time.

It is also worth noting that higher time frames typically see greater volatility, resulting in higher average drawdowns. Therefore, a well-balanced strategy is crucial in mitigating these risks and stabilizing returns.

Managing Drawdowns: Strategies for Investors

While you cannot eliminate drawdowns, you can manage their impact on your investment portfolio:

Diversification: Spread your investments across different asset classes (stocks, bonds, real estate) and sectors to reduce the impact of any single investment's poor performance.

The strategic implementation of asset allocation can lead to a significant reduction in drawdowns. For example, average drawdowns in portfolios with 100% equity can be quite severe (20% to 50%). In contrast, portfolios with balanced asset allocation experience much milder drawdowns (6% to 35%).

Regular Portfolio Reviews: Periodically review and rebalance your portfolio to ensure it aligns with your risk tolerance and investment goals.

Stay Invested: Panic-selling during a drawdown can lock in losses. Maintaining a long-term perspective and staying invested can help you benefit from market recoveries.

Risk Management: Use risk management tools and strategies, such as stop-loss orders or investing in low-volatility funds, to mitigate potential losses.

Conclusion

Drawdowns are an inevitable part of investing in mutual funds. By understanding what drawdowns are, why they occur, and how to manage them, you can make more informed investment decisions and stay on track toward your financial goals. Remember, the key to successful investing is not to avoid drawdowns altogether but to navigate them wisely.

Are you prepared to manage drawdowns in your mutual fund investments?

Disclaimer: The information provided in this blog post is for educational purposes only and should not be considered as financial advice. Investments in mutual funds and other financial products are subject to market risks and can result in financial loss. Past performance is not indicative of future results. It is important to conduct your own research and consult with a qualified financial advisor before making any investment decisions. The views expressed in this post are based on personal opinions and market trends at the time of writing and may change over time. Expected Draw Downs for 100% Equity Portfolio and Asset Allocation based strategy is basis our internal calculations, and may not be applicable to all individuals in general. We do not claim accuracy of calculations and it may be prone to errors. The author and the firm are not responsible for any investment decisions made based on the information provided in this blog.