Background
During a discussion about index investing, a question arose: Index investing seems simple, but what risks does it have? Can these risks be classified? This dialogue starts from basic questions and gradually explores the nature of risks and how to respond to them.
Part One: What Are the Risks of Index Investing
1. Does Index Investing Have Risks?
Q: Does index investing have risks?
Response: Yes. Index investing reduces the risk of individual stock selection, but doesn’t eliminate the risk of the market itself. Prices will fluctuate and draw down.
2. What Are the Main Risks of Index Investing?
Q: What are the main risks of index investing?
Response: Two types:
- Market Risk: Index price decline, i.e., drawdown
- Behavioral Risk: Making wrong decisions during drawdowns
3. Are All Drawdowns the Same?
Q: Are all drawdowns the same? All just price declines?
Response: Price declines look similar, but the underlying causes and nature differ. Different types of drawdowns require different response methods.
Part Two: Can Drawdowns Be Classified
4. How Many Types of Drawdowns Are There?
Q: How many types can drawdowns be divided into?
Response: Three types:
- Normal Drawdown: Cyclical market fluctuations
- Structural Drawdown: Liquidity shocks like financial crises
- Institutional Risk: Fundamental changes in the institutional environment
5. What Is Normal Drawdown?
Q: What is normal drawdown?
Response: Cyclical fluctuations of the market itself. Prices fall, but there is no fundamental change in corporate profitability or market structure. This is the market’s normal state.
6. What Is Structural Drawdown?
Q: What is structural drawdown?
Response: Significant decline caused by liquidity or credit crisis. Asset prices drop sharply in the short term, but the foundation of corporate earnings and expansion is not destroyed.
Typical examples: 2008 financial crisis, early 2020 pandemic.
7. What Is Institutional Risk?
Q: What is institutional risk?
Response: Fundamental changes in the institutional environment that lead to long-term restrictions on most companies’ profitability and room for expansion. This is not cyclical but structural change.
Part Three: How to Distinguish the Three Types
8. How Do You Distinguish These Three Types of Drawdowns?
Q: These three types of drawdowns all look like declines. How do you distinguish them?
Response: Core judgment criterion: Are most companies’ profits and scale expansion being restricted?
| Drawdown Type | Corporate Profitability | Corporate Expansion Room | Recovery Expectation |
|---|---|---|---|
| Normal Drawdown | Unaffected | Unaffected | Cyclical recovery |
| Structural Drawdown | Short-term damage | Foundation unchanged | Recovery after crisis |
| Institutional Risk | Long-term restricted | Long-term restricted | Uncertain |
9. How to Determine If It’s Institutional Risk?
Q: How specifically do you determine if it’s institutional risk?
Response: Observe the following signals:
- Are most companies’ profit growth being policy-restricted?
- Are companies being restricted from entering new markets or expanding scale?
- Are these restrictions temporary or long-term institutional ones?
If the answer is “long-term institutional restrictions,” you may be facing institutional risk rather than cyclical drawdown.
10. Can Index Distinguish These Three Types?
Q: Can the index itself distinguish these three types of drawdowns?
Response: No. Index only reflects price changes, not reasons. Distinction requires investors’ own judgment.
Part Four: Response Strategies for Different Drawdowns
11. How to Respond to Normal Drawdown?
Q: How should you respond to normal drawdown?
Response: Execute according to established rules, don’t change the system. Normal drawdown is market’s normal state and a necessary cost for long-term participation.
12. How to Respond to Structural Drawdown?
Q: How should you respond to structural drawdown (financial crisis)?
Response: Similarly execute according to rules. Although financial crisis is severe, the foundation of corporate earnings remains unchanged, and the market will eventually recover. Historically, investors who stuck to rules often gained excess returns after the crisis.
13. Do Different Drawdowns Have the Same Recovery Time?
Q: What’s the difference in recovery time for different types of drawdowns?
Response: The differences are significant:
| Drawdown Type | Typical Recovery Window | Historical Reference |
|---|---|---|
| Normal Drawdown | Several months to 1-2 years | Common market corrections |
| Structural Drawdown | 3-7 years | 2008 crisis recovered in ~5 years |
| Institutional Risk | Uncertain, potentially over 10 years | Japan post-1990 still hasn’t fully recovered |
14. What If the Recovery Window Is Too Long?
Q: What if the recovery window exceeds your investment horizon?
Response: This is a critical question. Even for structural drawdowns, if the recovery window is too long, you may need to consider adjustments:
- Investment horizon shorter than expected recovery window: May need to exit early or reduce positions, to avoid being forced to sell at lows when you need the money
- Investment horizon longer than expected recovery window: Can stick to rules, even consider adding to positions
Judgment criterion: Can your investment horizon cover the expected recovery window?
15. How to Assess Your Investment Horizon?
Q: How do you know if your investment horizon is long enough?
Response: Ask yourself these questions:
- When is the earliest I might need this money?
- If I’m still at a loss after 5 years, will it affect my life?
- If I’m still at a loss after 10 years, will it affect my life?
If the answer is “yes, it will affect,” then your actual investment horizon is shorter than you think.
16. How to Respond to Institutional Risk?
Q: How should you respond to institutional risk?
Response: Need to re-evaluate investment premises. If the institutional environment has fundamentally changed, the original index investing logic may no longer apply. At this point, consider:
- Whether to adjust asset allocation regions
- Whether to re-evaluate long-term expectations for that market
17. Why Is Distinction Important?
Q: Why is distinguishing these three types of drawdowns important?
Response: Because the response methods are completely different:
- Normal drawdown and structural drawdown: Stick to rules
- Institutional risk: May need to adjust the rules themselves
- Recovery window too long: May need to adjust based on personal investment horizon
If you treat institutional risk as normal drawdown, you may persist under wrong premises. If you treat normal drawdown as institutional risk, you may exit too early.
Part Five: Behavioral Risk During Drawdowns
18. What Is the Real Threat of Drawdown to Index Systems?
Q: What is the real threat of drawdown to index systems?
Response: Not the price decline itself, but loss of behavioral control—changing established rules at the wrong time.
19. What Is Index System’s Most Vulnerable Link?
Q: What is index system’s most vulnerable link?
Response: Changing rules due to emotion during drawdown. Whether normal or structural drawdown, changing rules often means exiting at the worst timing.
20. What Does Drawdown Really Test?
Q: So what does drawdown really test?
Response: Not market judgment ability, but:
- Can you distinguish types of drawdown
- Can you assess the match between recovery window and your investment horizon
- Can you persist when you should persist
- Can you adjust when you should adjust