One of the problems in designing good methods of financial investing is that no single method pays off through all cyclical fluctuations. There will be times when any given method experiences draw-downs and losses.
What most investment methods try to do is generate positive returns over the long run. One of the most common ways to do this involves taking exposures to various assets in more or less stable proportions. That way, it is hoped that some of the assets will always be generating returns, regardless of the state of the economic cycle.
Most rational asset allocations include a large proportion of equity and a large proportion of debt along with small proportions of unusual assets like precious metals, commodity exposures, etc. (We’re assuming real estate holdings aren’t included in financial assets but are considered as a separate category.) Usually we would expect such an asset allocation to have roughly 80-85 per cent invested in debt and equity combined.
The life-cycle theorists suggest that weights in asset allocation should be set according to the investor’s age. A young man should have high exposure to equity, while an elderly person should be more focussed on debt. That way, there is high growth with attendant volatility in the early stages of a portfolio, and stbility in the later years.
This is quite logical but it cannot be more than a rule of thumb. It is based on the assumption that business cycles are relatively short-term and can be safely ignored. We know that this is not necessarily true, however.
There can be long periods — 8-10 years or even longer — when an equity portfolio goes nowhere. Similarly there can be long periods of high inflation when debt is a guaranteed loser. If you happen to be of the “wrong” age at the “wrong” time, this system of rigidly allocating asset weight by age would give very disappointing results.
Active asset allocation
Any more active system of asset allocation leads back to a central problem. Active asset allocation implies being able to switch weights to take larger exposures in whatever is likely to perform well. But if you can guess correctly which asset is likely to outperform at a given point of time, you don’t need a system! However, if your guesses are wrong, you will probably land up in a bigger mess than with almost any consistent system.
High dividend yield stocks
One of the more logical methods of fiddling around with asset allocations is to look for stable income from equity, rather than rely purely on debt for the stable income. That is, try and build an equity portfolio that offers a high dividend payout. In the Indian context, the preferential tax-treatment of dividends versus interest makes this relatively easier to do. In effect, for somebody in the highest tax bracket, 1 per cent dividend equals 1.35 per cent interest.
The concept behind this is simple. There may be long periods when equity valuations are depressed. However, there will always be some companies that are making profits and handing out dividends. If you buy into such companies at a point when valuations are depressed, the dividend yield will be on the high side. As and when valuations recover, there could be an upside in terms of capital gains but that isn’t the primary concern. So long as the dividend yield stays reasonably high, the strategy works.
The equity for dividend yield method is conservative and extremely safe. You are unlikely to lose capital or even underperform debt yields by much. You are quite likely to end up with handsome capital gains in the long run. But it’s not a method that can be employed effectively during bull markets. When valuations are high, dividend yields tend to be low. So there could be long periods when allocations to this asset cannot be increased.
If you do this, do it in addition to your normal equity strategy. If you follow a passive SIP-oriented method, don’t break with that. Treat the equity for dividend allocation as a different asset with a different weight.
Another method, the “managed futures” concept, tries to exploit any trends that arise in derivative markets — forex, equity, or commodity. Here, the investor is looking for any sustainable movement — up or down — in any asset where he can acquire a leveraged position.
The methods are purely technical and the stress is on good management of positions. The investor is uninterested in the fundamentals of the underlying derivatives. Essentially if the moving averages (or more complex technical signals) suggest that a given asset will continue to move up or down, the investor takes a position and holds it, until there’s a trend reversal. It can only be applied with strong stop-losses and disciplined position sizes.
The advantage of this method of trend-following is that it allows the investor to play both sides of a situation — you can short a futures trend as easily as you can go long. The problems arise during phases of the business cycle when trends are choppy and sustained moves don’t occur.
The trend-following futures method is extremely dangerous. These are leveraged instruments, hence the gains and losses on them are magnified. The results of hedge funds that use such methods indicate that they have long periods of under-performance coupled with huge gains during the periods when these methods work.
Could it be possible to employ both methods in the same portfolio with a fairly small weight for each? For example, let’s say that an investor decides to give a weight of, say, 10 per cent to high dividend stocks in addition to giving a weight of, say, 5 per cent to trend-following derivatives. In such a case, the dividend yield portion should probably be pared off the debt portion of the portfolio because it’s not high risk. The trend-following portion should come from either the equity allocations or from unusual assets allocations. The categories are not “opposed” — there may be phases when both methods work, and phases when neither method works.
The investor must be prepared to lose a considerable proportion of the trend-following portfolio if his judgements are wrong. This is mad money in a sense — it could double very quickly or it could disappear. He should also be prepared to hold the dividend yield portion for at least a year, preferably longer, before taking any view on capital gains or erosions.
To sum up, there are phases when normal asset allocations don’t work. In some of those phases, a low risk strategy like dividend-yield investing could be fruitful. In some of those phases, a high-risk strategy like trend-following could also be successful. It’s up to the investor whether he chooses to tweak his asset allocation by following such methods.