When to take a step back from the stock markets

While this rise in retail investor participation indicates a shift in stock market dynamics, it does not necessarily mean that financial literacy has improved. To elaborate, before the pandemic, it was difficult to get individuals to start investing in stock markets. But now, the problem has reversed. Given the supernormal returns delivered by the stock markets since 2020 – 200% in about five years, it has now become a task in itself to convince investors to take a step back from stock markets, even when taking that step back is crucial.

Case in point: a prospective client who had approached me recently with sky-high expectations. To conceal his identity, let us address him as Harish Vitthal.

With the resolution of sorting out his finances in the new year, he sought my advisory services. He is in a leadership position at a corporate and has a decent corpus. He is looking to invest in the stock markets with the objective of growing his corpus sufficiently to pay for his daughter’s college fees. So far, so good. But this is where it gets complicated—his daughter’s fees are due in two years.

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Staying invested in stock markets when your investment goals are only a couple of years away is extremely risky and imprudent. In case of Vitthal, he has already accumulated ₹20 lakhs towards his daughter’s college fees. He expects the fees to be around ₹30 lakhs, due at the end of 2026. He is hoping to make up for the shortfall of ₹10 lakhs through his investments in stock markets.

His argument is that since the lows of 2020, the Nifty 50 index has delivered an annualized return of 25%. So, in the next two years, he expects his corpus to grow by 50% from ₹20 lakhs to ₹30 lakhs — the amount he needs for his daughter’s fees.

Vitthal’s most likely outcome—a shortfall.

This endeavor is fraught with risk because even though “pandemic investors” have been lulled into a false sense of complacency, the stock markets are anything but a safe space. If we look at the last two decades of Nifty 50 returns and calculate the annualized returns over rolling two-year periods, the median annualized return is only 12.9%. The median is the most likely scenario, and in this scenario, Vitthal’s corpus would grow from ₹20 lakhs now to ₹25.5 lakhs by the end of 2026. As a result, his corpus would fall short of his daughter’s college fees by ₹4.5 lakhs.

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The worst-case scenario is beyond grim. At an annualized return of -20%, assuming the worst, Vitthal’s corpus would fall from ₹20 lakhs now to ₹13 lakhs in two years. In this scenario, which has admittedly occurred only thrice in the last 20 years, his corpus would fall short of his daughter’s college fees by ₹17 lakhs. While unlikely, this scenario is not impossible.

Even though “pandemic investors” have been lulled into a false sense of complacency, the stock markets are anything but a safe space.

Imagine encountering a pandemic-like situation right when your daughter’s college fees are due. Is it prudent to bet your daughter’s education on the non-occurrence of such a tail event? Of course, going by the same logic, the best-case scenario where Vitthal’s accumulated corpus grows to ₹53 lakhs is also possible. But would you risk your daughter’s fees on an unlikely best-case scenario playing out?

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What should Vitthal do?

The situation would be vastly different if Vitthal had five to six years before his daughter’s fees were due. With longer investment horizons, the extreme positive and negative returns seen over short durations tend to balance each other out. This also allows investors to take higher risks, which can improve the returns expected from investments.

However. because Vitthal does not have time at his disposal, the most likely scenario would leave his corpus short by ₹4.5 lakhs when his daughter’s fees are due. In a worst-case scenario, this shortfall could lead to huge shortfalls. So, it would be advisable for him to limit his stock market investments and shift his corpus to safer fixed-income instruments. Unless he can top up his corpus, he should also consider alternatives such as an education loan to help cover the shortfall.

Ananya Roy is the founder of Credibull Capital, a Sebi-registered investment adviser.

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