Accept Mean Reversion & follow your Asset Allocation

Asset Allocation and Mean Reversion – If you understand the real essence of these two concepts, you will do better than 99% of the investors.

More importantly, if you are already utilizing these two concepts in your active investing, then you don’t need to read any further. You already know how important these two are. 😉

But if by chance you are still not aware of these concepts properly, then I am afraid that a theoretical explanation will at best, seem theoretical to you. 🙂 and you may really not realize how powerful these two ideas are.

Still, you should try to understand as much as possible about them.

I am not going into details here and… and you can find more from Google (or maybe I will write in detail someday).

But generally, the idea of mean reversion is that if an asset experiences years of above-average performance, chances are that it will become overvalued eventually. It’s natural. And once that happens, the direction would change and the prices would start falling to more reasonable levels again.So the periods of above-average performance will inevitably be followed by below-average returns. Similarly, periods of below-average performance will be followed by above-average performance. Mean reversion ensures assets return to ‘fair value’ after moving on either side.

So the periods of above-average performance will inevitably be followed by below-average returns. Similarly, periods of below-average performance will be followed by above-average performance. Mean reversion ensures assets return to ‘fair value’ after moving on either sides.

This is mean reversion for you in plain words.

And for lack of a better phrase, I think mean reversion is one of the most powerful laws of financial physics. And I am not exaggerating. 🙂

Different Assets follow Different Paths

You already know that all assets don’t perform alike. They just cannot!

In some years, equity would do well. In others, debt might do well. In some others, the winner would be gold or some other precious metal.

No one can correctly predict (one after other for several years) which asset will be the best performing one in a given year.

Take a look at the annual returns of stocks for last 15-20 years and you will know that it’s not necessary that stocks will do well every year… even though the average equity returns are better than all other assets. An average annual return of 15% in 10 years might mean that there wouldn’t even be one year with exact 15% returns even though the average of ten years would be exactly 15%. 😉 Averages can fool investors like the 6-ft tall man who drowned in 5-ft average depth river.

Good returns in last few years may give people the impression that volatility is nothing to worry about. But remember that equity is not a bank FD. It will move both ways. That is the price we pay for the potential to earn higher than risk-free rates of return.

So the fact is that in the ranking of annual returns, the leaders keep changing.

Reviewing historical asset performances teach us that mean reversion does and will happen over time. But you cannot predict when. The winners will become losers and losers will become winners some day.

And since most people cannot predict (correctly) when the tide will turn and which asset will outperform others in near future, it is futile to be completely in or completely out of the equity markets.

So simply say NO… to 100% equity or 0% equity. That is not for most people.

Instead, find out what is the right asset allocation for yourself and your financial goals and stick with the chosen strategy.

Deciding on the asset allocation for a financial goal is in itself very important. You can read more about it here.

One or the other asset in your portfolio will perform better than others. That’s perfectly normal. And that also doesn’t mean that you should sell all other less-performing assets and put money into the best performing one.

But you don’t need to turn a blind eye too.

When one asset starts getting ahead of long-term averages by far, then the mean reversion becomes imminent. At that time, a disciplined rebalancing strategy can help manage investments smartly and strategically. Rebalancing is the best practice for most investors because it enables better control of risk and more importantly, allows investors to take advantage of the phenomenon of mean reversion.

But you may ask…

How often to Rebalance your Portfolio?

It is not always clear what is the optimal level of rebalancing. But it can be done in following ways:

• Rebalancing on a fixed date – Calendar based Rebalancing – You rebalance your portfolio your original asset allocation once a year
• Rebalancing based on Percentage (or some other Trigger) – You rebalance every time the asset allocation tips beyond a certain trigger point.

So let’s say you begin with 60-40 allocation between equity and debt.

• Now in the first approach, you will rebalance the portfolio back to 60-40 on the first day of the calendar year. So if after a good year, equity component becomes 68%, then you will bring it back to 60%. Or if after a bad year it has gone down to 48%, you will bring it back to 60%.
• In the second approach, you will rebalance every time the allocation moves 5% away from original 60-40 allocation. Or at every 10% (it can differ from strategy to strategy).
• For smaller portfolios, rebalancing can also be achieved to some extent by managing the new contributions in such a way that it helps restore the asset allocation to originally targeted levels.

I totally agree that most people will find it difficult to rebalance as it seems counter-intuitive to sell a ‘winning’ asset in favour of a ‘losing’ one. It might even seem plain stupid!

But trees don’t grow to skies and bull markets don’t last forever. Mean reversion is a powerful force and it does happen…always. It can be delayed but cannot be avoided.

It seems difficult at first (as you need to monitor and need time). But it can be done as you don’t need to rebalance every time an asset overshoots your allocation by 0.1% or 1%. Taking the calendar-based rebalancing (like once a year) is fine too and doesn’t need much effort from you. Or if you want to be more tactical or opportunistic, you can take advantage of volatility and valuations and go for threshold-based rebalancing. (This seems attractive and glamorous but such active strategies can be challenging if you don’t know what you are getting into).

It’s up to you or your advisor how you wish to strategize your investment plan.

Infact, there are endless possibilities for boosting the returns of a portfolio using rebalancing strategy. But they come with higher risks which may not be suitable for everyone. You need to be willing and capable of assuming higher risks than the average investors when seeking higher returns.

But enough about rebalancing.

What holds the key is getting your initial asset allocation right.

So spend some time and find out what asset allocation is suitable for you. Once that is decided and implemented, the best option for most investors is to keep rebalancing their portfolio to ensure its risk and return characteristics remain consistent over time in all market environments.