The Circle of Life – Stock Markets Edition
Much like life, the stock markets also move in cycles.
But here’s a TL;DR before we move into the cycles of explanation in this blog –
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Market Cycles – Causal or Incidental?
In a market cycle, there is a deviation from the mean on either side with time. It starts at the bottom, with smart, early-stage investors getting into a buying mode while the prices are still low. They’re the ones with foresight. As the curve works its way towards a peak, more and more buyers get in. Markets hit all-time highs, and the bull market run continues to make investors profits.
However, there reaches a peak when the glitz of it all starts making investors jittery. This is called the point of maximum risk. The point is achieved because the markets have sustained growth, and rumours and the slightest red flags negatively impact share performance. This drives investors into sell mode, and a bear market begins. A bear market is a moment of maximum opportunity because buying is cheaper.
The dip continues until the lowest point is hit, only to rise again. Historically, we have seen all markets crash, only to recover in the long-term and grow over time. Each phase in the cycle causes the next one, so the relationship is more causal than incidental.
It is important to note that not every correction can be called a cycle. There have been significant falls in the markets over the last decade (think 2018 US-China trade wars or the very recent pandemic), but the recovery has been too rapid for it to be called the end of a cycle.
The current bull market run started back in 2009 after the massive crash of 2008. While historically, bull runs have been 3-4 years long, this one will probably extend for several more years. In fact,u003cemu003eThe current bull run in India is 18 months old and hasn’t yet seen a significant correction since March 2020u003c/emu003e. Click To Tweet
Emotions can move
Now, it is essential to understand what moves the market cycles. While the GDP, companies’ profits, credit cycle, and more affect the markets, investor sentiment mainly moves it. If you think hard enough, it all looks pretty bizarre. The idea of money itself is so faith-based. Value is attached to something only because a majority of people choose to acknowledge its worth. So, emotions rule the markets.
When so many factors affect the markets, there is bound to be fluctuations. Volatility is an intrinsic function of the market cycle. The performance of your investments is heavily linked to these fluctuations. Remember that guy from financial services and products ads who narrates the disclaimer at breakneck speed? This is exactly what he’s also been trying to tell us.
Markets go through distinct phases, and our behavioural biases make us take emotional decisions while trying to time the markets, which is the most significant cause of sub-optimal portfolio performances. But since volatility is an inescapable evil, the question stands –
How do we tackle volatility?
Two things can prove extremely helpful in tackling volatility –
- Dynamic asset allocation
- Factor-based stock selection
Dynamic Asset Allocation
Dynamic asset allocation is an effective portfolio management strategy that frequently plays around with the mix of asset classes in a smallcase to suit market conditions. It helps lower the volatility of a smallcase through allocations to assets that have lower or negative correlations, such as bonds and gold. It’s an excellent way for investors to deal with numerous market fluctuations.
Take a look at the equity markets in the years 2017 and 2018.
And now take a look at the performance of two portfolios during this time –
- One with 80% equities and 20% bonds
- The other with 20% equities and 80% bonds
The equity majority portfolio had a better performance in 2017, but the bond majority portfolio gave better risk-adjusted returns in 2018. A dynamic allocation of funds to different asset classes could have potentially beaten markets.
Factor-based stock selection
Factor-based stock selection is a strategy that chooses equities based on factors that are associated with higher returns. Several macroeconomic, and fundamental and statistical methodologies are applied to analyse and select the stocks. Factors that investors have identified include growth vs value, market capitalisation, credit rating, stock price volatility, and so on.
Equity buckets to tackle volatility can be based on factors like:
- Momentum or trend following
- Value or choosing the undervalued stocks
- Growth or picking high growth stocks
- The quality or picking stocks with good earning quality
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The Balanced MFT smallcase is based on a rationale that is a perfect amalgamation of the above two themes and aims to outperform the markets in all cycle stages – both volatile and trending. This is achieved by dynamically allocating smart beta factors and asset classes based on the changing market regime. Other than equity, the smallcase also contains bonds, gold, and international ETFs, which are dynamically given higher weightage when the markets are volatile.
The historical performance of this portfolio has beaten benchmarks by a wide margin in all market conditions.
Balanced MFT is an investor favourite that has performed well in terms of both returns and risk.
Who is this smallcase for?
This smallcase was curated by Wright research for absolutely anyone who wanted to invoke the Ask the Expert lifeline in real life for tackling volatility in the markets! If you’re an investor with a balanced risk profile looking for steady appreciation in capital over the long term, this one could be for you!
Who curated this portfolio?
The team that helps you strike the Wright balance!
The folks at Wright Research are passionate individuals focused on bringing a quantitative investing revolution to India. With decades of experience amongst them, their expertise in quant, AI and finance adds the cherry on the cake. They are driven by their purpose of democratising the access of AI and quant-driven investment products for everyone.
For further information, head to https://www.smallcase.com/manager/wright-research.
Wright Research’s offerings come with a small subscription fee that you can check out on the above website. The subscription includes regular rebalance updates (this smallcase is currently rebalanced monthly), access to their channels, weekly newsletters, and more!
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