Framework and Guidelines for Handling Panic Situations in the Market

By Amit Rupani

I feel it is very difficult to build a process to avoid a big portfolio crash when markets crash. But a logical framework can work as a guideline to help be level-headed. It's a good time to use common sense when it becomes difficult to think through the options thrown at you by the market during carnage times.

I used to panic when the market crashed like a house of cards. Just to be clear – I didn't get panic attacks when I looked at all that red or that I got sleepless nights. Clicking “sell-all" button and exiting the markets never occurred to me, especially when I got the feeling that the pendulum of emotions is clearly in the extreme zone. But my panic was mainly driven by my inability to take rational long-term oriented decisions for my portfolio, and feeling ineffective as far as brain functioning was concerned. It's the anxiety which got the better of me disrupting the decision-making process that often leads to poor choices. Maybe it's just the way I am naturally wired. My brain doesn't function well under time crunching situations because of which I cleared CFA level 3 on my third attempt. It was not that I didn't know the material that I prepared for in my first two attempts, but my brain used to shut off knowing that the clock was ticking against me and my brain froze more and more with every tick.

I realized I need to nurture my natural deficiency. There was desperate need for guidelines and framework that I needed to work upon to help myself in situations when everyone is losing their mind. You would keep slogging and grinding if the market is consolidating in a range. Generally, the portfolio of a buy-and-hold investor like me is not going to do anything in consolidating markets. But, it's the volatility that gives that opportunity to make those “right" decisions that makes the material portfolio difference. It's the framework and practice of how to go about keeping calm and taking rational decisions during panic situations, which makes the real difference of taking one's portfolio capital to the next level. Hence, I went on to creating that framework for myself few years back that has been very helpful to me.

Having a prioritized buy-list handy during good times happened to be the magic wand for most of my problems to handle panic situations. You never know when the market lights are going to turn amber from green, hence having it ready during green times is the key. If you have a prioritized buy-list ready, your brain doesn't need to wander or it will not be allowed to get frozen, and the buy-list works as a program that has been written for the brain to simply follow the instructions.

History has shown that investors experienced more 10-15 percent drawdowns compared to larger drawdowns at index level. And there are good odds that in the future we are going to experience more 10-15 percent drawdowns than 40-50 percent drawdowns. Hence we should spend a lot more time to have a framework in-place for 10-15 percent corrections.

Below I am sharing my thought process that went into building the framework for me for 10-15 percent correction situations and I am sharing it with the hope that it will help a new investor as a starting point and they can modify it as per their own investment objectives. It is a fluid, generic framework and will evolve with my increasing experience and increasing coverage universe of business that I understand. I would not say that it is complete in nature or is the best one that works in all situations for all type of investors. No. There is no one right way or one right answer in stock markets in panic situations. It all boils down to the individual's preparedness and their situation with cash availability, investing style and temperament, type of capital one is dealing with, and ability to take drawdowns. So keep that in mind as you read the following:

1) Average-up your winners: Firstly, I give top priority to averaging-up the portfolio winners. If I have bought a structural business or a business with strong sectoral tailwinds (which are likely to continue in near future too) that has already been a winner and has further room for addition as far as percentage allocation is concerned, I go ahead and add more of it.

2) Dispassionately, cut your losers and future losers: Rationally, I shouldn't wait to cut my losers until market corrects itself. Losers should be taken care of much before. But still if they happen to be part of my portfolio after correction, I just generate some cash by ruthlessly selling my losers. Use these funds to add to much stronger businesses. I referred to cutting “future losers" too. If the correction is event driven, you would know that event is going to lead certain sectors in medium to long term downtrend, confirming future fate of certain businesses and stock prices.

3) Reshuffling the portfolio: I perform a periodic exercise asking myself if I understand the business better with every quarter that passes by. On many occasions you won't know everything about the important levers that move the needle for that business or would not have discovered unique insights about critical factors and hence these would be smaller positions in the portfolio. The thought process is to get a foot-in-the-door and then get better understanding and scale it up as conviction increases. Sometimes I have many positions in the tail consuming anywhere from 5-15 percent of the portfolio. Such a panic situation is the best time to reshuffle some of the low conviction businesses to higher conviction businesses. I can always get back to lower conviction businesses in future.

4) A core/compounder position gets higher priority than value plays: My biggest learning from the market has been to try to get into a situation where you have to take least number of decisions. With a compounder you buy it and hold it as long as the thesis is working out for you (hopefully for many years). But usually a value play (a 2x) – if you are lucky, and if your thesis worked out as expected, you tend to get out of the position when your target is achieved and then you need to work on redeploying that cash to work. Don't forget the tax implications on selling it. The goal is to build a tax efficient portfolio of businesses that you can hold on during good times and bad. And per my experience not all 2x thesis have worked out as expected. Many have turned out to be 0.5x proving out to be mental torture eating away lots of energy that can be spent on understanding better businesses. Hence, stronger quality businesses get priority.

5) Have a plan/rule for how you would buy that position: It's not just about buying “right" but how you go about accumulating it may turn out to be much more important. It is very rare that I have gone all-in in creating a new position during panic times. Most of the time, a staggered purchase has worked out well for me. It's OK if you happen to just accumulate 2.5 percent of the position during the correction, but your goal was to make it 5 percent of the portfolio. In panic situation, usually it gets worse before it gets better. So, don't mind accumulating remaining 2.5 percent at higher level once dust settles down. As always, I have my next purchase price with quantity ready as I go about accumulation my position in any situation. Creating these rules to how to accumulate beforehand and sticking to them keeps me sane during rough times and good times in the market.

Along similar lines, there is a fluid framework that I attempt to follow for situations when market corrects 25-35 percent and then another for >50 percent. It dives more into how to go about thinking to reshuffle the positions since I would have run out of cash by then. And the aggressiveness options that can be applied when index drops more than >50 percent. I think this framework for higher correction scenarios is not that generic in nature and can be used as reference point by everyone. It is more customized in nature and applies specifically to my investment objectives and my investment style driven by how I handle my personal finances. So I will not be able to share anything about it here.

Finally, having a write-up of guidelines to be followed during panic times has been as much beneficial for me as a write-up for why I am buying a business.

I thought to share my knowledge and how I attempted to overcome my challenge of facing markets during panic times.

Happy Investing!

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Amit Rupani, CFA is an Independent Investor, practices Value Investing principles, manages money for long-term wealth creation through Equities asset class. Email: rupaniamit@yahoo.com