Protect your capital first!

The Indian equity market, represented by Nifty, is still down by 18 per cent year-to-date. Nevertheless, at the end of March, it was down by around 39 per cent. It has recovered 32 per cent from its recent low on March 23, 2020.

If an investor would have exited the market after the initial 20 per cent fall in the market and entered only after the market had recovered 20 per cent, he would have been sitting at a loss of only 12 per cent, as compared to 18 per cent by someone who had remained invested throughout this period.

One of the major reasons for such an outperformance by the first investor is because he had restricted his loss to 20 per cent. Even if he had forgone the first 20 per cent gain while the market was still recovering, he would have incurred a lower loss. This is the power of protecting your capital first. There is a high correlation between downward protection and long-term outperformance. This is because protecting from losses in the falling markets leaves more capital to grow than when the market rises again.

Quantifying downside protection and upside participation

The above rule applies to every asset class. In a mutual fund, there are some specific ratios that help the investor to understand the performance of the funds during the rising and the falling market.  Downside and upside capture ratios are a pair of ratios that quantify what percentage of gain or loss, an investment achieves on an average in a falling or a rising market. The ‘market’ here refers to the returns by any indices to which the fund is benchmarked.

An upside capture ratio, greater than 100 per cent, indicates that the investment outperformed the benchmark during positive periods on average. It should not be construed that the fund outperformed the benchmark in all periods in which the benchmark return was positive. A downside capture ratio of less than 100 per cent indicates that the fund outperformed the benchmark during negative periods. This means that the fund has declined lower than its benchmark.

So, if you have to consider only one ratio, you should consider the downside capture ratio to select funds. Nevertheless, the history of the fund should be long enough to justify the downside ratio, which clearly represents consistency. A lower history of the funds may not help you to get the right picture.