As investors, we face two important risks. The first risk of investing is the Drawdown Risk – the loss from the peak. The second risk of investing is the Low Return Risk – the under-performance vs. expectations over a stretched period of time.
First, the drawdown risk. A drawdown is the peak-to-trough decline during a specific recorded period of an investment, fund or commodity security. A drawdown is usually quoted as the percentage between the peak and the subsequent trough. Because of the drawdown risk, investors naturally panic at the worst possible moment (the trough) and some start to sell their shares. In many cases, the share price stabilized quickly and not much long-term harm was done by that drawdown alone. The real damage is caused by investor reaction to the drawdown.
Second, the Low Return Risk. Low returns are a risk because an extended period of under-performance causes investors to abandon their previously selected strategies (asset allocation, sub-asset classes, and individual managers) and switch out at a very bad time. This locks in accumulated under-performance and switches to a typically over-valued alternative solution, creating permanent damage to the portfolios.
Risk as anything that causes investors to take actions that destroy value of their portfolios. Larger than expected drawdowns and lower than expected returns destroy value. First, because they drag down performance. And second, because they make investors abandon their ‘long-run’ strategies, miss out on the potential bounce back, and jump on new things that outperformed recently but are about mean-revert. All of this is not new and well documented and it creates a vicious cycle of actual returns significantly lagging the average returns of the approaches that investors are trying to implement.
Many investors in Indian mid and small cap companies are staring at the drawdown risk currently. Look at your investments objectively and decide if selling now is the best option for you. It is likely that these investors will face low return risk in these investments for some time. It will be important to remember long term goals of your investments and accept periodical low returns as a part of the journey.
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