A member of our extended family expired sometime back.
He was financially savvy and did everything right (as far as my understanding about managing money is there). Saved a lot… to an extent that it seemed a little too much.
But then, having accumulated almost all the money that he would ever need… he left. Suddenly and without any warning and at a fairly young age.
It was sad.
This highlights one thing:
We always know how much money we have.
But we never know how much time we have.
Read that again.
As an advisor, its my duty to help people save and invest well. But people should realize that money alone is not everything. If you keep strangulating yourself and save and build assets so that ‘one day’ you would do anything you want, then its possible that ‘that particular one day’ might never come for you.
So find the balance.
And remember: Many may not have that much time left that they think they have.
Do what is necessary. Letting life slip away is not what should be allowed.
Today morning, my wife reminded me that it was exactly 6 years ago that I started Stable Investor. And as I said last year too, it was the day I was reborn. Though the realization came much later. 🙂
I cannot thank you all enough.
Last 6 years have been wonderful for me, and I owe that to you all. Together we have taken steps to use money to live a life that we really want. And that is extremely important.
I really look forward to continuing this wonderful journey with you all in years to come.
To celebrate the occasion, I am doing a Book Giveaway where I will be giving away 3 books. One each to 3 different winners. Here are the details.
00:00 Hrs on 17th November to 23:59 Hrs on 25th November
How to Win?
There are 5 simple things to do. You can do just one or as many as you wish.
Each action will give you one entry into the contest. So if you just do the 1st, you will have one entry. If you do 3 of them, you will have 3 entries. And if you do all of them, you will have 5 entries. Simple.
So here is what needs to be done:
I have created a short form that you need to fill:
Your name and email address
Message for me (good, bad, whatever you wish)
Give emails of 3 people who you think will benefit from reading Stable Investor. Please don’t give spam ids. I know you will come clean. 🙂 Read note section too.
Remember, each of these five actions will give you 1 entry into the contest. If you perform all 5 actions, then you will have 5 entries (which means higher chances of winning).
Declaration of Winners?
Three winners (for one book each) will be chosen. I will announce the winners on 26th November.
Email ids you give as reference for people who might benefit from getting introduced to Stable Investor: They will get an email from me in few days about whether they would like to receive my articles, etc. I will clearly ask them to unsubscribe if they do not want to receive my mails. I really do not want to spam people. So those who would not unsubscribe would receive my emails. And even then, they can unsubscribe anytime in future.
I suggest you only give ids of those who might be genuinely benefited by my posts.
Winners will be selected in a random drawing from all eligible entries received. I am not Elon Musk who can hold a live event. 🙂 So you need to believe me that I will make it as random as possible.
Winners have to provide an Indian address for delivery of the books.
One of the problems in raising concerns about valuations is that you can end up looking like a party pooper. And if future markets movements do not happen in line with what you are expecting, you can even end up looking like a damn fool!
But that’s fine. I don’t intend to predict anything here.
It’s just that if you look at the data, it does trigger some concerns. I am a simple investor who wishes to buy low (and maybe occasionally sell high too). 🙂
Unfortunately, the ‘buying low’ part doesn’t seem to be easily happening these days.
For Nifty50, the valuation of the index today is in excess of PE-26.
Now historically, this is rare! And has happened very few times in the last couple of decades. In fact, there seems to be a sort of hidden upper ceiling when it comes to valuations and markets have trouble keeping above that ceiling.
Have a look at the chart below.
The blue line is actual Nifty level. The red line is hypothetical Nifty level at PE24 at that time. The green line is hypothetical Nifty level at PE12 at that time.
Clearly, Nifty seems to have trouble staying above PE24 (considered overvalued) and below PE12 (considered highly undervalued). Whenever it reaches either of these two levels, it seems to bounce off in opposite direction! (read full analysis here).
Also, a move beyond PE 25-26 has been historically rare and generally resulted in steep falls. And as can be seen from tables below, markets do not spend a lot of time on the extremes:
But does it mean a sharp fall or a full-fledged market crash is just around the corner?
I don’t know.
River water seems to be flowing above the danger mark. But will it flood the city or not is something that I cannot predict. And markets have this evil habit of surprising. So who knows they may remain at these levels for much longer.
Ofcourse every now and then, the valuations will be stretched and go where it hasn’t gone in last many years. But it’s important to consciously remember that sooner or later, the reversion towards mean happens. And this is what learning from history and identifying basic patterns helps you do.
I regularly publish index PE data and as many of you might have noticed, is showing a lot of red. Check here for the latest update in November 2017.
I have done detailed analysis earlier which shows (or seems like modestly predictive) that future returns tend to be low when investment is made at very high valuations. To summarize, it is something like this:
(Please do note that above are average figures. And depending solely on averages and ignoring the actual deviations can be catastrophic. Read about the risk of depending only on averages and please… never forget about it.) 🙂
Now interestingly, the Nifty PE has remained in and around 24 for last one and a half year. And as of now, we have been flirting with PE26 and above(s) for the last couple of months.
I did some further slicing & dicing of data to see what happens to index returns (in next 1, 2 and 3 years) when investments are made in PE24 and above zones. Here is the data cut:
It’s self-explanatory and unfortunately, paints a sorry picture.
Do note that the correlation seems very strong but the number of data points is not very high.
All these hints towards something not being right. But the party still seems to be on…
Maybe, the earnings will surprise and bring down valuations without hurting market levels. Or maybe, the constant flow from retail investors is and will support the markets for longer. Or maybe this time it is ‘really different’ and we will continue to reach newer heights on the mountain of valuations. 😉
But like all bull markets where new highs are being regularly made, it’s very easy these days to write off valuations as something of an unnecessary botheration. Everything is moving up like there is no tomorrow. Investing in IPOs is once again perceived to be a quick way to make money. But trees do not grow to skies for a reason. And valuations matter. Believe it or not.
I don’t intend to predict a big crash here.
Markets have a mind of their own and will crash when they want and not when we predict. But I feel that we should not throw caution out of the window. We should be alert. Alert to the possibility of lower future returns.
But since I have used Nifty50 PE data as a representative of the market, let’s make note of few things which should be kept in mind:
Nifty of today is much different from Nifty of earlier years. Infact, there is a regular change in index constituents. So it’s easily possible that high PE is the new normal. After all, in earlier years Nifty was made up of low-PE companies while these days it’s populated with high PE ones (read this interesting analysis).
Another aspect linked to above point is that PE data provided by NSE is based on standalone numbers of Nifty companies. It would be ideal to use consolidated numbers as many Nifty companies have subsidiaries that have a significant impact on earning numbers. This has a much larger effect now than it would have had in yesteryears. But NSE publishes Nifty PE using its own set of criterias and decisions.
For all practical purposes, one cannot wait for investing when valuations are rock-bottom (like PE 12-14). If that is the case, the investor will end up on many bull runs that begin at 15 and end at 27. 🙂
Investing in individual stocks is a different matter altogether. You can always find undervalued stocks in overvalued markets. There can be stocks that continue to command high premiums and still deliver spectacular returns year after year.
I don’t know what the so-called smart money would be doing now. But moving out of equities completely is not something that I do. Ofcourse, focusing on asset allocation with an eye on valuation and operating in preferred tolerance bands is something that should help most people.
Nothing more to add from my side here. Here is an old tweet that acts as a sort of guide 😉
Things to do in market PE>26 – Tk Holiday 26>PE>22 – Read books 22>PE>15 – Invest 15>PE>12 – Invest Heavily 12>PE – Take Loan/Steal & Invest
I keep telling everyone that for long-term goals, it’s best to have an investment plan that has a major equity component. But what about the goals that are not decades away and rather just a few years away?
What are the saving and investment options for such short-term financial goals?
Before we proceed, we need to define what short term is.
What exactly is Short Term?
There is no standard definition. Everyone has their own.
But you can say that financial goals that are less than 5 years away can be considered to be as short-term goals. Many of you may feel that period of 5 years is too long to be categorized into short term. If that’s the case, then maybe you can accept 3 years as a reasonable definition of the short term. Happy? 🙂
So the approach to save for different short-term goals may differ (if you are willing to do it diligently). Or else, one can always justify keeping things simple.
But for the sake of bringing more clarity to your short-term goal identification and prioritization, you can map your goals in the below grid:
As might be clear from above grid, once you identify and grid your goals as above, you can adopt different investment plans for each if need be.
Now since we are talking about short term investments, you cannot afford to take huge risks by investing all your money in assets like equities, etc.
For critical goals that you can neither delay nor downsize, taking risk can be stupid. For example – the goal of paying for your house downpayment after 1.5 years. But for good-to-achieve goals (like foreign trip after 3 years), you can still take some risk if you feel comfortable with it. But even then, taking too much risk is once again…stupid.
One important thing to understand is that when it’s about short-term goals, it means we are concerned about just a few years. So a small difference in returns (earned by taking higher risks) may not be too beneficial, as the power of compounding doesn’t work much in small periods. So why take too much risk??
The idea mainly is to save and invest in a way that there are little to no fluctuation in returns and absolutely no loss of capital. Any loss of capital that happens (if a risky investment is made) has very less time to recover. This is the reason why equity is not suitable for short term goals.
Saving & Investment option for Short Term Goals
So let’s see what are some of the useful saving (investment) options for short term goals:
Bank Fixed Deposits
This is the obvious choice for most people.
The interest rates are typically 6% to 8% per year. FD rates in India vary from one bank to other, but not by a lot. So do check out which bank is best for fixed deposits. It’s another matter that you don’t want to end up opening relationships with several banks every year in search of best FD interest rates. 🙂
But the interest on FDs is taxable and hence, pre-tax and post-tax returns for fixed deposits are different. Post-tax FD returns will generally not even beat inflation. These are best suited for periods less than 3 years. It’s also good for parking some money as an emergency fund.
RDs are also very popular and do not need any special introduction.
If you are a conservative saver and do not have the lumpsum amount to put aside, RD can come to your rescue. It allows regular periodic savings. But like FDs, the interest on RD is taxable and lowers your post-tax returns. It’s still good for saving up for near-term goals systematically.
Now that was briefly about FDs and RDs.
But what about the alternative to fixed deposits FDs? What are other possible options if you wish to save (or invest) for short term? Are there better investment alternatives than fixed deposits that offer better returns than FD?
Ofcourse there are. But they come with their own set of risks. Let’s see these options.
Debt funds are slightly riskier than bank deposits but allow you to take a shot at somewhat higher returns. In good years, top debt mutual funds can do quite well.
These debt funds come in various varieties like liquid funds, ultra-short term funds, short-term debt funds, etc. But each one is best suited for a different purpose.
Generally, liquid funds are best suited for parking money for few months. Ultra short term funds are good for upto a year or near abouts. For more than that, short term debt funds are good enough.
Debt funds are fairly safe but some risk is always attached while investing in these type of funds. Do not expect bank FD type zero-volatility here. That is the major difference between debt funds and fixed deposits. Liquid funds are least risky among these. Then come ultra-short term funds and then short-term debt funds.
Debt funds though more tax-efficient than FDs, aren’t tax-free. If redeemed before 3 years, capital gains tax has to be paid. If held for more than 3 years, capital gains tax is applicable but with indexation benefits. And this is where debt funds win over fixed deposits if you check out any FD vs debt fund calculator. But debt funds can be looked at for even less than 3 years. Ofcourse choice and category of debt fund will matter.
I must say here that debt funds are gaining popularity these days. And rightly so. But FDs too are decent enough for periods like less than 3 years (ofcourse you need to consider interest rates). But for many, peace-of-mind is more important than post-tax returns. 🙂 And to be blunt here, most people give unnecessary importance to tax saving where there are other bigger financial decisions to get right.
I suggest that you do not go big bang into using debt funds if you do not have an idea of how volatile they can be. Slightly lower returns in FD (that too not everytime) is still fine as the period in question is small.
Corporate Fixed Deposits
With bank FDs giving low returns, many people get attracted to high-interest corporate FDs. These are just like bank fixed deposits but the difference is that you are parking money with a corporate and not the bank. Also, for the additional risk that the saver is taking, corporate FDs offer higher interest rates than bank FDs. Usually, company FDs offer 2-3% higher than bank FDs.
So for people who are unable to look far beyond bank FDs (and have no experience of debt mutual funds), corporate fixed deposits do offer an attractive investment option.
But do not ignore the risks just because these FDs are offering higher interest. Always scrutinize the credentials, credit rating (stick with AAA types) and repayment record of the company before handing over your hard earned money to them.
Don’t be too adventurous in your greed to earn a percentage point more here or there. There have been cases of defaults by companies offering FDs too. You don’t want money planned to be used for your short-term goals stuck up anywhere. Isn’t it?
Debt Oriented balanced Funds
If you want to be adventurous (and most people shouldn’t be) and are investing for not-so-critical goals that are more than 3 years away, you can even consider investing a small part of the money in debt-oriented balanced funds.
These have a small exposure to equity so there is a possibility of getting little extra returns. But I assume you know the risks with equity. It can even go against you and at times, returns might be lower than fixed deposits too!
Want to Earn More (by taking More Risk)?
This is not advisable for most people.
If you insist, and
You are aggressive (even though the time horizon is not suitable for aggressiveness), and
Your goal is more than 3 years away
then, you can take slightly higher risk. I repeat this may not be suitable for everyone.
For short-term goals and where you are willing to take higher risks as the goal is not very critical, you can take some equity exposure (like 20-30%) and stick with debt options for the remaining 70-80% of the investment amount. But as the goal day approaches, you should reduce your equity exposure.
In a way, this approach is similar to investing in debt-oriented balanced funds. But it allows for more control as you can control the amount of equity that you wish to get exposed to.
What about Recurring Short term Financial Goals?
There are some short-term goals that are recurring in nature. Like saving for travel (holiday), school fees or electronic purchases.
Obvious and natural reaction to such goal is to go for Recurring deposits. But one can also consider some varieties of debt funds for such goals too depending on the frequency of goal recurrence.
What to do when Long & Medium term goals become Short term goals?
This is bound to happen one day or the other.
Suppose you began investing for a goal that is 15 years away. Initially, you took 70% equity exposure. Now let’s say 10 years have passed. So what should you do?
A theoretical approach would be to reduce your equity exposure continuously:
5 years left (11th year since investing): 60% Equity + 40% Debt
4 years left (12th year since investing): 40% Equity + 60% Debt
3 years left (13th year since investing): 30% Equity + 70% Debt
2 years left (14th year since investing): 10% Equity + 90% Debt
1 years left (15th year since investing): 0% Equity + 100% Debt
The actual plan might differ depending on the goal type, market conditions and many other factors.
But in general, when long-term financial goals start becoming medium and short-term financial goals, you should slowly start de-risking your investments and reduce exposure to risky assets like equity. (Do read how real goal-based investing works to help you achieve your financial goals).
Traditionally, FDs and RDs have been the popular choice for short-term savings. But as you have seen, there are several other alternatives to fixed deposits that offer potentially higher tax-efficient returns than FD.
But I would still caution you: and say that the investment option that you chose for short-term goals should be such that you don’t end up taking unnecessary risk just for the sake of slightly higher returns. It may not be worth it as the goal is just a few years away and your life won’t change dramatically if you earn 1 or 2% more for just a couple of years.
Thousands of people rely on mutual fund star ratings for picking good or best mutual funds to invest in. It’s a popular metric amongst investors and advisors alike.
These stars (ratings) are provided by agencies like Morningstar, Value Research, Money Control, CRISIL, etc. Most of them rate funds on several parameters and come up with a star rating – which ranges from 1-star to 5-stars. Top funds get 5-stars and ones at the bottom get 1-star.
It’s a simple method of comparison for investors and advisors. Naturally for fund houses, it is also a free method of advertisement for their well-rated products. 😉
Most people believe that a 5-star rated fund will perform better than all others. But truth is that… this is not necessary.
Are Mutual Fund Star Ratings really useful?
Before we move on to discuss this important question, let’s understand why these ratings are so popular first.
The number of funds available is overwhelming and unnecessarily large and most people don’t know how to pick the right mutual fund schemes. So they take the easy way out and end up relying on star ratings.
In words of the founder of Morningstar, the star rating system ‘is a way to whittle down a big universe into something more manageable.’
I agree here.
Mutual Fund (star) ratings are designed to help investors quickly identify funds to consider for their investments. For starters, they give investors a quick-and-dirty opinion on the chosen fund within minutes. And this is perfect for our era of time-poverty.
But the problem arises when investors rely solely on these ratings to pick funds.
They treat these stars as a guide to future performance and high star rating to be a definite buy signal.
This is not the right approach. It is plain stupid.
Mutual fund ratings by themselves do not guarantee high returns in the future.
It is not at all necessary that a 4- or 5-star rated fund will always perform better than a 3-star one. But it is generally expected that over a period of time, better rated mutual funds do perform better than lower rated ones. But there are numerous instances where lower rated funds have outperformed higher rated ones.
In this post, I don’t intend to talk negatively about rating agencies. There is nothing wrong with the concept of star ratings. These are based on actual data and solid maths.
The idea instead is to remind investors that they need to look beyond star ratings. Many investors rely blindly on star ratings and have questions like:
Should I choose only 5 star rated mutual funds?
Should I choose only mutual funds that are either 4 or 5 star rated?
Should I switch out of my mutual fund investments every time my fund’s rating is downgraded?
These investors need to wake up and understand that the star ratings are not enough.
But investors alone should not be blamed. Many financial advisors love star rating systems too.
They take this easy route and use star ratings to justify their advice. 🙂 I have seen this being done by many advisors! Even many of you would have experienced it. It’s a cover-your-@$$ type of service… An advisor can say, ‘I’m going to put you in this fund, it’s a 5-star fund,’ …and if something goes wrong the advisor can shunt blame to the rating agency.
But keeping aside advisors and rating agencies for a while now…
Why you should not blindly depend on ‘Mutual Fund Ratings’?
Ratings do a decent job of accurately analyzing a fund based on its past performance (and few other criterias). But the downside is that this isn’t a good guide to future performance.
You cannot use these ratings to correctly predict future performance. And that is what most people forget.
Remember the standard disclaimer that has become too common for its own good?
“Past performance is no guarantee of future results.”
It is not just a disclaimer. It’s reality!
Most fund rating agencies do suggest that their star ratings are backward-looking assessments. And since past performance is no guarantee of good future performance, one should consider the limitations of these ratings when making investment decisions based on them.
At best, these ratings should be considered as a sort of filtering mechanism when selecting mutual fund(s) to invest in. Both for lumpsum and regular SIP investments.
If necessary, then investors should only use this ratings data as a starting point, combine it with other important factors (consistency, suitability, fund objective, portfolio, expenses, fund manager’s track record and experience, investment process followed, integrity of the fund house, etc.) for shortlisting funds.
My view is that these ratings may not be even a good starting point for research. I prefer taking the data and analyzing it myself.
And think of it, it would be really great if picking funds were as simple as looking at how many stars it has earned. If rating agencies believed in their ratings, they would be running big portfolio funds which would be investing in these high-rated funds. 😉 That is something to ponder about.
And it’s not just me who is being sceptical here. Even Morningstar’s CEO voices similar thoughts here:
We recognize and have often acknowledged the limitations of a measure like the star rating that’s based on past performance, but we also believe it can usefully tilt the odds in investors’ favor, when combined with other research and tools.
We’ve long described the star rating as a worthwhile starting point for research that can help investors make good decisions, when combined with other research and tools.
I say this again – mutual fund ratings as a concept is fine. But as an investor, you need to focus on more important things.
Instead of looking to invest in all the top rated mutual funds, you first need to ensure whether you got the category of the mutual funds right or not. And that is after you have decided which financial goals you are investing for.
Choosing the highest rated fund in the wrong category can kill your investments and you risk not achieving your financial goals. Being in the ‘Right’ fund in right category is much better than being in the ‘best’ fund of a wrong category.
The ‘best’ mutual funds suited for your real goal-based investing needs may not necessarily be 5-star rated. They may not be category toppers too. Also, a high ranking for a particular fund does not mean that it will be necessarily suitable for each and every investor.
Another issue is that different strategies (fund’s investment strategy) or styles go out of favor and then come back after few years. So if you exit a fund that has dropped in rating due to their particular reasons, chances are that you will miss out when the strategy returns with all guns blazing.
This is something that most people don’t realize when going via ‘I-only-bother-about-fund-rating’ route.
Is it a Mirage?
Recently, a Wall Street Journal (WSJ) article titled The Morningstar Mirage created a lot of drama in the investment fraternity. And the subtitle of the article got straight to the point:
Investors everywhere think a 5-star rating from Morningstar means a mutual fund will be a top performer – it doesn’t. 😉
In the article, WSJ concluded that the top-rated funds attracted a majority of investors’ money (in the US) but most didn’t continue performing at that level. Unsurprisingly, the rating agency in question hit back (link) with its counter-views protecting itself; and in essence claiming that their ratings were not supposed to be predictive and they should be a starting point for investors selecting funds. Their CEO also pitched in with his views (link).
If you go through all the articles related to this particular episode, you will understand that the rating companies also know about the shortcomings of star ratings but they have a business to run. 😉
Let’s talk about the possibility of conflict of interest here.
I am sure most mutual fund rating entities are professionally run. And since most information is in public domain, chances of wrongdoing seem limited.
But who knows… 😉 😉
A fund that is rated well (lots of stars) will attract more investments if fund houses pitch it strategically to advisors and investors. Its easily possible that investors would continue to pour fresh money into top-rated funds even if their performance declines – just because the rating is still high.
So whether they agree or not, the fact is that the rating companies are a big beneficiary of their own ratings. Think about it. I know a few things. Others might know as well. But I am not saying anything more here… 😉 If you know what I am pointing to, you will understand. Else, ignorance is bliss.
And with a sustained rally in Indian equities for last many years, equity is no doubt turning out to be an attractive asset class. At such times, its all the more necessary that the role of mutual fund rating agencies is critically and subjectively assessed.
Maybe, the Fault is not in ‘Stars’ but in Us
Here I quote from an article by Barry Ritholtz that has some apt words:
Retail and professional investor alike seem to ignore the fact that every single document ever generated by any investment-related firm has a warning on it to the effect that “Past performance is not an indicator of future returns.” Every chart ever drawn, each investing idea back-tested and every single historical comparison is testament to how little mind humans pay to that disclaimer.
To borrow from and paraphrase the Bard, the fault lies not in the stars, but in ourselves.
Thus, it should come as no surprise that misunderstanding what fund ratings mean is a very typical error made by, well, just about everyone. It isn’t a forecast of future returns, nor could it be.
If it could successfully do that, [Mutual Fund Rating companies] would have long ago set up a hedge fund to profit from its newly discovered abilities to identify winning investments.
Sounds logical. Isn’t it?
I reiterate that mutual fund ratings are fine as a concept and provide useful insight into a fund, how it has performed in the past and how it invests. But they are not meant to be used in isolation or as a predictive measure.
When it comes to things like ratings, you cannot build a perfect system. Never. But it’s your hard earned money. You should atleast know the limitations of factors on which you are basing your investment decisions.
The best way to invest in mutual funds in India is not by just looking at the mutual fund star ratings. Ideally, investors need to use data, do some homework and estimate how a fund might perform in future. And that is very important. The rating system alone does not have complete information for making such a subjective judgment.
So should you ignore mutual fund star ratings altogether? Or are mutual fund ratings useful? Or are mutual fund ratings of no use? And will 5 star rated funds perform better than all others? Are star ratings the best way to choose a mutual fund?
I have already shared my thoughts. It’s best if you decide about the final answers to these questions yourself.
This is the October 2017 update for the State of Indian Stock Markets and includes historical analysis and Heat Maps of Nifty50 as well as Nifty500‘s key ratios, namely P/E, P/BV ratios and Dividend Yield.
Please remember that these numbers are averages of P/E, P/BV and Dividend Yield in each month. Neither Nifty50 heat maps nor Nifty500 heat maps show the maximum or the minimum values for each month. Also note that NSE publishes PE ratios based on standalone numbers and not consolidated numbers.
Caution – Never make any investment decision based on just one or two ‘average’ indicators (Why?) At most, treat these heat maps as broad indicators of market sentiments and a reference of market’s historical mood swings.
Dividend Yield (on last day of October 2017): 1.08% Dividend Yield (on last day of September 2017): 1.17%
Now, to the historical analysis of Nifty500 companies…
As the name suggests, Nifty500 is made up of top 500 companies which represent about 95% of the free float market capitalization of the stocks listed on NSE (March 2017).
Nifty50 on other hand is an index of 50 of the largest and most frequently traded stocks on NSE. These represent about 63% of the free float market capitalization of the NSE listed stocks (March 2017).
So obviously, Nifty500 is comparatively a much broader index than Nifty50.
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.
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.