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Understanding Drawdowns: The Key to Managing Risk and Liquidity in Portfolio Strategy

Understanding Drawdowns: The Key to Managing Risk and Liquidity in Portfolio Strategy

Investments inherently come with risk and volatility, especially when the underlying is equity. Portfolio investors use the core and satellite approach to allocation when building a portfolio; where the core forms the base (allocation around 60-75%) and is generally a more stable part of the portfolio and the satellite part, Generate alpha to increase overall portfolio return.

The satellite part involves taking tactical calls based on expected market movements in the short to medium term and tends to exhibit high volatility. While it offers the potential for increased returns, it also brings increased risk. One of the critical factors investors should consider before embarking on tactical allocation is asset class decline. Drawdown measures the decline in an investment’s value from peak to trough and is a key indicator of the asset’s volatility and potential risk.

Understanding drawdowns is crucial for investors, especially those with shorter investment horizons or those using a core and satellite approach in their portfolios.

Understanding the disadvantages of Tactical Allocation helps an investor:

1. Measuring Volatility and Risk: During the 2008 financial crisis, global stocks experienced declines of over 50% and took years to recover. An investor who tactically turned to stocks during this period could have faced serious losses if he had not been prepared for such a downturn.

2. Recovery Time: The time it takes for an asset to recover after a decline is another critical factor. If the time horizon for holding an investment is short and the decline is severe, the asset may not recover in time to provide the desired return.

3. Impact on Portfolio Performance: In the core and satellite approach, investors typically use the satellite portion of their portfolio to seek alpha through tactical allocation. However, a significant decline in the satellite portion could negatively impact overall portfolio performance.

For example, if an investor allocates 25% of his portfolio to a high-risk asset with a potential downside of 30%, a downturn in the market could reduce the total value of the portfolio by 7.5% (25% x 30%). part remains stable. This decline in performance can be particularly detrimental in an unstable market environment.

Historical Disadvantages of Nifty 50:

Decline Start Date End Date Decline Duration Recovery Days Recovery Date
-38.43% 14-Jan-20 23-Mar-20 69 165 09-Nov-20
-28.18% 09-Nov-10 20-Dec-11 406 487 31-Oct-13
-21.81% 03-Mar-15 25-Feb-16 359 138 06-Sep-16
-16.62% 18-October-21 17-June-22 242 105 11-November-22
-14.41% 28-Aug-18 26-Oct-18 59 112 02-Apr-19

1. Covid-19 Market Crash: In March 2020, the Covid-19 pandemic led to a rapid decline of around ~39% in the Nifty 50. However, the market recovered quickly and the decline was fully corrected within 8 months. Investors who understood downside risk and tactically allocated to stocks were able to benefit from the rapid recovery.
2. During the 2010-11 crisis, Nifty 50 experienced a decline of ~28% in a period of 1 year and 1 month. Recovery took approximately 2 more years, making it unsuitable for short-term tactical strategies. Investors who made tactical allocations to stocks suffered significant losses, and many were unable to recover their investments in the timeframe they planned.

Therefore, it is important for an investor to educate themselves about the different asset classes, their characteristics, the risks involved, and potential returns before tactical allocation. Understand the balance between risk and reward. Each asset class has a distinct role in the portfolio.

> Equity – Building wealth over the long term
> Debt – For capital maintenance and regular income
> Gold – Inflation Hedging and Hedging in Uncertain Times

Historical Declines
Stock and Debt Indices 1 Year 3 Years
Stylish 50 -52.2% -13.8%
Nifty Midcap 100 -59.4% -12.0%
Nifty Smallcap 100 -71.0% -19.9%
CCIL Treasury Bill Index 1.9% 2.5%
NIFTY 5YR G-SEC INDEX -1.5% 2.9%

Therefore, an investor with a short investment holding period should not invest in an asset class (such as equity) with high losses as the asset may take much longer to recover. These investors should park money in liquid or short-term debt instruments that are safer and preserve capital.
Solution:
Understanding drawdowns is a critical aspect of risk management in tactical allocation. Investors should consider the potential decline of an asset class, the time required to recover from the decline, and the impact on overall portfolio performance before making tactical decisions.