To Be A Good Investor, Respect Market Cycles

In ancient Egypt, a Pharaoh had two unique dreams.

In the first one, he dreamed of seven fat and beautiful cows. Then he saw seven thin and bony cows. And, the thin ones ate the fat ones.

In the second dream, he saw seven heads of full and ripe grains growing on one stalk. Then seven thin, dried-out heads of grains. And, the thin heads of grain swallowed the seven good ones.

As the dream kept repeating, it intrigued him to find out what they meant. He called for wise man Joseph to interpret those dreams to him. Joseph explained to him – both the dreams meant the same. In Egypt, seven years of prosperity would be followed by seven years of famine.

He suggested to the Pharaoh: “Put someone in charge of collecting and storing 25 percent of food grains during the seven good years. This will ensure that people don’t starve during the following seven bad years when there will be a scarcity of food.” Impressed with this proposal, the Pharaoh not only put Joseph in charge of collecting and storing food grains, but also made him the chief advisor in the coming years.

Looking at the recent trends and returns, we assume that these trends would continue in the future too. This way of thinking is called recency bias. Avoiding recency bias by being aware of the cycles and re-balancing portfolios can help us become better investors.

The Principle Of Mean Reversion

Most variables in investing revert (return) to mean (averages). That is, it is assumed that investments will tend to move to the average price over time, whether it is return on equity in business or multiple to earning or interest rates. The charts below show that interest rates in India fluctuate between 5 percent to 9 percent, PEs from 10 to 25 times and RoEs that peaked at 30 percent earlier is currently at an all-time low of 10 percent.

Unfortunately, as investors, we tend to believe exactly in the opposite. For example, in 2000, we felt that stock prices of information technology companies will continue to grow forever and likewise infrastructure companies in 2008. In the same spirit, we feel that the current pessimism in most stocks will never change. In debt, interest rates in India in the last 18 years have fluctuated between 5 percent to 9 percent. At 9 percent, when most macro news is negative, we assume rates will go up further. Similarly, at 5 percent, we feel they will go down. In 2013, we felt gold will continue to rise, and equities will continue to stagnate (as they were since 2009). Within equities too, there are long periods when growth stocks do well, and then comes the time for value stocks to grow. And based on these trends, we end up investing in products that currently look good refusing to learn from the past.

A Sense Of Perspective

We must respect the long-term realities and the turning points as against measuring a product based on what it looks like today. How do we apply this to investing? Like Joseph advised the Pharaoh, when times are good, save 25 percent food grains for the bad times.

For example, as mid cap stocks are falling today and bond prices rising, most investors would love the comfort of bonds and ignore mid caps. Whereas, Joseph would have advised keeping 25 percent aside from bonds and actually invest in good mid cap companies or funds. Likewise, the reverse is also true. When times are euphoric in mid and small caps, slow down your investments and reinvest partly out of them.

Many funds in this cycle of 2017-18, when small caps were peaking, gave this signal and shut shop to new money.

This was again a classic case of recency bias.

A very simple way of respecting these cycles would be to invest in asset allocation funds. They adjust their exposure to under-performing asset class by adding more of it and reducing from the better performing asset class. In 2018, at the peak of the recent highs in equities, these funds reduced equity exposure to 20-40 percent and stayed in bonds; and very recently after a 25 – 40 percent correction in most stocks, they have started investing more in equities.

The reason why most of us don’t like such automated asset allocation funds is the absence of adventure and the sense of loss of control as they take away the power from us for deciding the asset allocation.

Let’s test this principle with some evidence. Since 2005, gold has shown a compounded annual growth rate of 13.18 percent, the Nifty has earned 13.6 percent, short-term bonds have earned 7.68 percent and U.S. equities have grown by 8.82 percent. Left to ourselves, we would have invested in each asset class at the peak of its performance and earned single-digit returns with high volatility.

As fund managers, while it is always tempting to tell our investors that this is a good time to invest, we should respect the laws of nature and advise the investors to rebalance asset classes when they reach extreme levels. Accordingly, you can either increase or even at times, reduce your exposure. I also understand that doing this may sound good while reading this article but being rational and disciplined in the real world is a rare gift most of us don’t have.

After all, the Joseph of today may not interpret your dreams, but will definitely help you in achieving them.

Kalpen Parekh is President at DSP Investment Managers.

The views expressed here are those of the author, and do not necessarily represent the views of BloombergQuint or its Editorial team.