When a stock rises or falls, mean reversion can help rebalance your portfolio

Published: February 22, 2019 12:03:38 AM

Most investors when they see stocks fall by XYZ per cent they calculate in their mind the fall from its high and average price that it was trading before and would come to a conclusion that it is cheaper and will come to its fair price so let us buy.

Stock markets: Mean reversion can help rebalance your portfolio (Illustration: Shyam Kumar Prasad)Stock markets: Mean reversion can help rebalance your portfolio (Illustration: Shyam Kumar Prasad)

By Dinesh Thakkar

Psychologically we all trade using mean reversion approach. We may not understand properly how asset allocation and mean reversion work but isn’t there any time in your life when you think that XYZ stock has fallen by 30% in last one month so it is ripe for a bounce as the price would again come to its average?
Most investors when they see stocks fall by XYZ per cent they calculate in their mind the fall from its high and average price that it was trading before and would come to a conclusion that it is cheaper and will come to its fair price so let us buy.

Asset class cycles
Generally, mean reversion is that if any asset price experiences under average performance, chances are that it would become undervalued and if any asset price experiences above average performance, then that asset would become overvalued. Usually, any asset will come back to its average as it will be difficult to remain overvalued or undervalued for long unless fundamentals change the story. Whenever an asset is overvalued, direction would change and price would start falling to more reasonable levels. So in short, mean reversion ensures that asset returns to fair value after moving on either side.

Every asset class has its cycle. Like equity would see 3-4 years of bull, 1-2 year of consolidation and three years of the bear cycle. In the same way, debt would have its own cycle of ups and down. Let us say average return for stock market for the last 10 years would be 15%. Now, this doesn’t mean that every year we would have seen 15% return as some of the year we would have seen negative return and some of the year more than 20% return.

Rebalancing portfolio
Market moves both ways and we all know that leaders keep changing. Reliance Industries is a classic example where it wasn’t participating in Nifty rally since 2012-2017 and in 2018 it was a leader in lifting index to life time high. Similarly, IT pack was a leader in 2017-2018 but were not participating during 2015-2017 and auto sector were leaders in 2016-2018 but now struggling.

So one never knows when it would be top or bottom in any asset class or in any sector but reviewing historical asset performance teaches us that mean reversion will happen over time and winners will become losers and vicse versa. So when any asset or sector starts getting ahead of its long term average by a fair margin, then mean reversion becomes imminent and investors should adjust their portfolio accordingly. That is when rebalancing is needed.

How often should one rebalance their portfolio? It could be on a fixed date like once a year or when one see any sector move beyond a certain percentage. One should not just rejuggle sectors but different asset class too. For example, if one has a 60-40 allocation of equity and debt. Now suppose equity component becomes 70%, you bring it back to 60% and if there is a bad year and it comes to 46%, then bring back the equity component to 60%.

So in case sequity is giving good results and is above long term average returns, we scale back our holdings in equity and focus more on debts and vice versa. I know that most people find it difficult to rebalance as we are selling our winning asset in favour of losing an asset. This might even sound stupid but remember there is no such thing as forever.

Bull market is not there forever neither is bear market. We all know sector rotation happens and by looking at the long term average return we can judge which sectors will rebalance. So be greedy when others are fearful and be fearful when others are greedy.

The writer is chairman & managing director, Tradebulls Securities

Get live Stock Prices from BSE and NSE and latest NAV, portfolio of Mutual Funds, calculate your tax by Income Tax Calculator, know market’s Top Gainers, Top Losers & Best Equity Funds. Like us on Facebook and follow us on Twitter.

Switch to Hindi Edition