How to gain from market cycles

Year 2019. As a handful of large-cap stocks continued their upward march, Ms X made what seemed like a counterintuitive decision. She began trimming her exposure to outperforming large caps and systematically increased allocation to beaten-down quality mid and small caps trading at attractive valuations. Her colleagues questioned this move away from 'safety'. Most market pundits were preaching the need to stick with 'quality large caps.' Fast forward to 2020. After the Covid market crash, the broader market rally has seen mid- and small-cap funds delivering annualised returns of 39-44 per cent, a substantial outperformance over large-cap funds' 29 per cent returns. Ms X's decision had added an extra 2-3 per cent to her portfolio returns compared to those who had remained heavily tilted toward large caps. While the above story is hypothetical, the message isn't. It demonstrates how strategic portfolio shifts can enhance returns. Also, note that this outperformance was not due to timing the market. Ms X had, in fact, mastered the art of riding market cycles, following the popular market principle of 'mean reversion'. Mean reversion, what's that? You've probably heard the saying, "What goes up must come down." That's the essence of mean reversion. In investment terms, it's the idea that prices or returns tend to revert to their historical averages over time. So, if a particular segment of the market - whether a stock, sector or investment style has been on a hot streak or in a slump, it's likely that it will return to its long-term average. Think of mean reversion as the market's way of balancing itself out. Just like a pendulum

This article was originally published on November 15, 2024.