"Everyone has a plan 'till they get punched in the mouth." - Mike Tyson | This is so much true in the context of Draw-down as well.
We believe we can withstand a deep draw-down, but that draw-down becomes a reality, all hell breaks loose with most investors running for cover (read, Sell at whatever price markets are willing to buy)
Investing in Large Cap is nice, but don't bother being on Twitter where you cannot showcase how the stock you picked went up 10X. You should be lucky if they double in 3 - 5 years at best. Boring!
Mid Caps are interesting in the sense that they can double faster than a Large Cap but requires much higher skill set since prices are way off their lows and our brains don't really want to buy stocks that seem to be in mature phase.
And then there is Small Caps. This is the real playground for those who believe in finding the next big thing. Why stop at 10X when 1 to 100 is easily possible?
In 2008 - 09, the Nifty Small Cap Index had a maximum draw-down of 77%. Its like if your peak equity was worth a Crore, now you had around 23 Lakhs worth. Can you Sleep with that kind of draw-down? 
Mid Caps weren't any better, only consolation was that rather than have 23 Lakhs of your Peak Equity, you now had 30 Lakhs. But carnage was similar
And then you had Large Caps, India's Best and Brightest and one where you weren't looking for massive returns and yet your Crore of Equity is now worth a piddly 40 Lakhs
As much as we think our Guts can stomach draw-downs of 50% or greater, I believe most of us will start puking the moment it starts going below 30%, panicking when it hits 50% and throwing the towel at 60 to 70%.
One way is to plot the equity curve and take a stop when the curve passes by the 30th mile mark. Its a valid and simple way of limiting losses. But there is a issue
The Issue is that not every fall is a copy of the 2008 which means that markets don't really go down as much as they went in 2008 every time they fall. If you get out & it starts to bounce back, what is the Plan?
A secondary and IMO, a better way is to reduce risk not by getting out of the market but having a allocation mix that can withstand a 70% draw-down while still being able to hold to your horses, in this case Equity.
Assume you cannot digest more than 30% draw-down in your wealth. Given that info and the knowledge we have with regard to previous falls, what should your Allocation to Small & Mid Cap (either direct or through Funds) and Large Cap be?
The simplest way is 60:40 split between Equity and Debt with Equity being totally in Large Caps. This way, even if markets crap & go down 50%, your wealth will not go down more than 30%.
But the kicker to returns is provided by Small Cap. Its like the Optionality that @nntaleb speaks about. So, how to address that within the said equation?
To have a small cap component and yet stay within the 30% mark, we can invest in the following ratio Small cap: 10%, Large Cap: 45%, Debt: 45%. Even at historical max draw-down, you aren't going to lose more than 30%.
And finally, what if you think you "are the man" and wanna do only Small Cap or Debt? The ratio then comes down to a simple 40% in Small Cap & 60% in Debt. Again, at max draw-down you are down just around 30%
Of course, if only life was as easy as Tweeting Gyan out. But the more I think, more I am sure that there are only very few options where I can stay in the game & not crap out than having a solid Asset Allocation mix.
As of yesterday, my Equity Draw-down hit 14.5% which is painful. But if I were to take my Asset Allocation into consideration, I am way fine.
As @VohiCapital rightly points out, we tend to look only at Equity and get alarmed. Add Debt to your Calculation and its much more soothing. After all, Debt is there for a purpose. /*End of Thread*/.
