Forest fires & Markets
Forest fires always start by one of two ways - naturally caused or human caused. Natural fires are generally started by lightning, with a very small percentage started by spontaneous combustion of dry fuel such as sawdust and leaves. Fires caused by human intervention can be due a range of reasons from carelessness (for eg a carelessly dropped cigarette) to arson.
But what causes a forest fire to thrive – is the presence of combustible material. An abundance of dried leaves, twigs and shrubs. Dry weather & strong winds also help a forest fire spread. Forest authorities normally carry our controlled burns before the summer season and develop fire-lines to reduce the risk of large-scale fires ahead of time.
In other words there are the immediate reasons for a forest fire- natural or human and then there are the pre-existing initial conditions – presence of combustible material, dry weather & winds that determine how damaging the fire eventually proves to be.
The reason I refer to this framework is the question that I am being asked the most in recent days-why is the market falling and how could it fall so sharply with wide spread damage? The reality is that periodic corrections are part of the nature of equity markets. And those who can stomach the higher volatility of Equities earn superior returns from the asset class over time. By the way even forest fires are arguably a part of the natural eco-system, but that is beyond my domain.
Was it the Oil prices, current account & fiscal pressures or rising rates or Fed tightening that caused this fall? We can never be sure of the reasons or know beforehand. But I would also submit that one of the initial conditions that precede a sharp and damaging correction as witnessed this year is typically valuations in the expensive zone. The subdued volatility that was witnessed in 2017 may also have raised complacency. In other words when you have the pre-existing condition of high valuations, the chances of a damaging forest fire that spreads quickly causing much damage, also goes higher.
That is just the way it is. That is why every investor or his financial advisor must have a plan that accounts for the outbreak of forest fires. You can never be sure of the natural or human forces that will cause a forest fire or the exact initial conditions that precede the outbreak. Note - forest fires can break out in any asset class- fixed incomes, equity, Property, Gold and hence the need for diversification across asset classes. Diversification across asset classes is not to be interpreted as a maximization strategy, it is a means to ensure that the risk along the journey to your financial goals is something you can tolerate and live with. And one of the key considerations in your asset allocation framework needs to be “valuations” because it contributes significantly to the conducive conditions for the outbreak, spread and damage from forest fires.
Mutual Fund investments are subject to market risks, read all scheme related documents carefully.