Background
There are mainly two approaches to asset allocation —
In the bandwagon approach - one chases the best performing assets and broadly follows the crowd. In the contrarian approach one focuses more on core value and enters assets that may be out of favour.
The contrarian approach to asset allocation, if followed judiciously, can be rewarding. It combines a full range of fundamental and technical analysis, evaluating assets continuously — in the search for assets that are likely to reverse its past trend. It is not about just blindly doing the opposite of what the market is doing. It is about identifying assets that offer true value.
Rationale
One of the key reasons for using a contrarian approach to asset allocation is the cyclicality of asset classes. There are also some asset classes that are complementary to the others. For instance, when interest rates go up, it hurts the bottom line of companies and hence equities are impacted negatively. On account of a spike in inflation last year, interest rates went up sharply — this was one of the key leading indicators that triggered the initial fall in Indian markets.
Similarly, gold is globally used as a safe investment avenue. When the outlook turns negative on stocks, investors move to safer asset classes like gold. While the Sensex dropped from a close of 20,301 on January 1 2008 to 13,802 on July 8 2009, a whopping 50% drop, gold prices in the global markets yielded an absolute return of 11%. An investor who took advantage of this trend would have topped up the good stock market returns, with gains in gold commodity. Cycle trend anticipation is the backbone of the contrarian approach to asset allocation. Different asset classes perform well at different times and timing the market is always a challenge. A well-balanced portfolio helps achieve best risk-adjusted returns. The right way to get the best of every asset class is proper asset allocation keeping in mind one’s risk appetite, the market cycle of each asset class and the time period one intends to stay invested.
A practical approach
A key to the successful practice of the contrarian approach is that investors should avoid unnecessary risk by being sufficiently diversified. The contrarian approach to asset allocation not only helps reduce portfolio risk by including investments that are negatively correlated; but also enhance returns by timely rebalancing of assets.
While the traditional school of thought believes in keeping one’s asset allocation fixed, a contrarian would work on a variable asset allocation pattern, depending on the outlook to the asset classes. In the first situation, the market is low, while the future outlook of equity is positive. Hence, the higher equity allocations in the contrarian approach. When markets run up and are at a high and the outlook to equity becomes negative, then one realigns the asset allocation and increases the allocation to debt and gold as shown in the second scenario. This example is simplistic. In reality, the asset allocation would be changed in phases. The success of the investor would depend on whether one was able to make this transition prior to the change in market cycle.
Monitoring and re-balancing
Consistent monitoring is essential to ensure that best returns are achieved at the relevant risk level. When any asset class delivers very high returns, its composition in the portfolio automatically changes. However, rebalancing too quickly can have a negative impact. For example, the last bull cycle started when the BSE Sensex was around 3,000 points in April 2003 and hit a high of 20,869 on January 19, 2008. An investor who was happy with a good 100% returns would have missed most of the rally that followed.
A few TIPS:
There are mainly two approaches to asset allocation —
- The Bandwagon Approach and
- The Contrarian Approach.
In the bandwagon approach - one chases the best performing assets and broadly follows the crowd. In the contrarian approach one focuses more on core value and enters assets that may be out of favour.
The contrarian approach to asset allocation, if followed judiciously, can be rewarding. It combines a full range of fundamental and technical analysis, evaluating assets continuously — in the search for assets that are likely to reverse its past trend. It is not about just blindly doing the opposite of what the market is doing. It is about identifying assets that offer true value.
Rationale
One of the key reasons for using a contrarian approach to asset allocation is the cyclicality of asset classes. There are also some asset classes that are complementary to the others. For instance, when interest rates go up, it hurts the bottom line of companies and hence equities are impacted negatively. On account of a spike in inflation last year, interest rates went up sharply — this was one of the key leading indicators that triggered the initial fall in Indian markets.
Similarly, gold is globally used as a safe investment avenue. When the outlook turns negative on stocks, investors move to safer asset classes like gold. While the Sensex dropped from a close of 20,301 on January 1 2008 to 13,802 on July 8 2009, a whopping 50% drop, gold prices in the global markets yielded an absolute return of 11%. An investor who took advantage of this trend would have topped up the good stock market returns, with gains in gold commodity. Cycle trend anticipation is the backbone of the contrarian approach to asset allocation. Different asset classes perform well at different times and timing the market is always a challenge. A well-balanced portfolio helps achieve best risk-adjusted returns. The right way to get the best of every asset class is proper asset allocation keeping in mind one’s risk appetite, the market cycle of each asset class and the time period one intends to stay invested.
A practical approach
A key to the successful practice of the contrarian approach is that investors should avoid unnecessary risk by being sufficiently diversified. The contrarian approach to asset allocation not only helps reduce portfolio risk by including investments that are negatively correlated; but also enhance returns by timely rebalancing of assets.
While the traditional school of thought believes in keeping one’s asset allocation fixed, a contrarian would work on a variable asset allocation pattern, depending on the outlook to the asset classes. In the first situation, the market is low, while the future outlook of equity is positive. Hence, the higher equity allocations in the contrarian approach. When markets run up and are at a high and the outlook to equity becomes negative, then one realigns the asset allocation and increases the allocation to debt and gold as shown in the second scenario. This example is simplistic. In reality, the asset allocation would be changed in phases. The success of the investor would depend on whether one was able to make this transition prior to the change in market cycle.
Monitoring and re-balancing
Consistent monitoring is essential to ensure that best returns are achieved at the relevant risk level. When any asset class delivers very high returns, its composition in the portfolio automatically changes. However, rebalancing too quickly can have a negative impact. For example, the last bull cycle started when the BSE Sensex was around 3,000 points in April 2003 and hit a high of 20,869 on January 19, 2008. An investor who was happy with a good 100% returns would have missed most of the rally that followed.
A few TIPS:
- A diversified approach across various asset classes is important to success. E.g. Equity, Debt, Gold, Commodities, Real Estate, etc.
- An understanding of the correlation between asset classes is vital to the contrarian approach. Only use asset classes that you can track.
- Study market cycles, lest you exit too early and miss a bigger market opportunity. Risk should be the basis of most switches.
- Think long term - most asset classes deliver returns only in the long term. Contrarian style for a short term investor can be very damaging.
- A phased approach to realigning the portfolio (switches in asset composition) can be used to reduce the dependence on 'timing the market'.
- Keep your financial goals in mind while doing your asset allocation.
- Do not get emotionally involved. "Fear and Greed" are two emotions that result in taking irrational actions that are not financially rewarding.
