Moderator - if you think this post can be moved to an existing better suited thread, please do so. I didn’t find one, hence created a new thread.
Sorry for long post. But I hope your time spent reading it will be worth it.
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 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 Mr. Market during carnage times.
I used to panic when market crashed like 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. May be its just the way I am wired naturally. 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 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% drawdowns compared to larger drawdowns at index level. And there are good odds that in future we are going to experience more 10-15% drawdowns than 40-50% drawdowns. Hence we should spend a lot more time to have a framework in-place for 10-15% corrections.
Below I am sharing my thought process that went into building the framework for me for 10-15% correction situations and I am sharing it with the hope that it will help a new investor as a starting point and they would 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 below lines:
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 % allocation is concerned, I go ahead and add more of it.
2) Dispassionately, cut your losers & ‘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 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. An example here should help to understand what I mean. In Oct 2018 when IL&FS issue unfolded – it was relatively easier to predict that road ahead for certain NBFC businesses will be full of potholes making them “future losers”. I owned both Indiabulls Housing Finance and Bajaj Finance in my portfolio then. Both of them winners with BF a much bigger winner in comparison. I ruthlessly went ahead and cut Indiabulls Housing Finance (3% of the portfolio then) in one go and bought Bajaj Finance with all the proceeds in one go. Looking back, luckily, this move worked out well for me. So the point is to identify not just losers but future losers too and act rationally to it.
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. Thought process is to get 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% of the portfolio. Such 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 learnings from the market have 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. Not to forget the tax implications on selling it. 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 rarely that I have gone all-in in creating a new position during panic times. Most of the times, staggered purchase has worked out well for me. It’s OK if you happen to just accumulate 2.5% of the position during the correction, but your goal was to make it 5% of the portfolio. In panic situation, usually it gets worse before it gets better. So, don’t mind accumulating remaining 2.5% at higher level once dust settles down. 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% and then another for >50%. 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%. I think this framework for higher correction scenarios is not that generic in nature that can be used as reference point by everyone. It is more custom 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 write-up for why I am buying a business.
I thought to share my learnings and how I attempted to overcome my challenge of facing markets during panic times. But I know above guideline/framework is not a perfect one and has a lot of room for improvement.
We have many amazing investors on this VP platform. I request others (especially investors who have gotten grey hairs by spending time in the market 
) to share about how they evolved to handle panic situations. How did you get better at handling curve balls that market throws at you during panic times? What is/are the particular thing(s) that you do differently now to take rational decisions during panic? Any particular real example that comes to your mind that can help us learn from it, would be great.
If you are a new investor with a framework that has worked well for you in panic situations, please don’t hesitate, come ahead, and share your work with everyone. This platform will always be hungry for quality work. And there is always to learn from everyone regardless of the market experience one has.
Cheers!