This week's post talks about the power of diversification, and market sentiment post Jan 2008.
For a second, imagine that you are in Jan 2008. The market has been growing a lot but of late its slowed down. You are not sure where the market will go now... sounds familiar?
How would you have allocated your money then? Which model would you choose, Model 1, 2 or 3? And how would you decide?
How to Choose between Models 1, 2 and 3?
The short answer is obviously that you should diversify across models. But to understand why and how much in each model, keep reading.
First let us look at the theoretical differences between the 3 models.
Model Comparison
Models 1 and 2 are based on a stock universe of NSE500. That means they select large cap, Midcap or even small cap stocks without any bias.
Between Model 1 and 2, the only difference is in how they select stocks. Model 2 is made for the lazy man, who doesn't want to look at his/her portfolio too often. It essentially picks stocks for a much longer period than Model 1, at roughly 2 trades a month. Model 1 keeps switching often between stocks, to stay with the stocks with highest momentum, which practically means approx. 5 trades a month.
Model 3 has a niche stock universe of only NSE Midcap index stocks. That means it has lesser no of stocks to choose from. It also uses a rotational momentum strategy, but since the universe is smaller, it has lesser switches. It requires roughly 3-4 trades a month.
So the above tells you that Model 1 and Model 3 are both having great returns of approx. 25% CAGR over the long term.
Let's go back to 2008 to see the returns of each model. Have you chosen one of the models yet? Maybe the back test results would help you choose.
Year Wise Model Returns - Luck or Strategy?
We know that all the models give great returns of 20%+ CAGR on average, but that doesn't work in the short term.
Just a reminder, that in Jan 2008, no one thought the market would ever crash (except the guys on Wall Street selling junk bonds) and in October or so, the market did finally crash.
So let's look at how our models performed relative to each other from Jan 2008 onwards.
The years like 2008, 2010, 2011, 2013, 2014, 2015, 2016, 2018, 2020 ie. 9 out of 13 years, we saw the 3 models perform almost as good or as bad as each other.
But there are some outstanding years like 2009, 2012, 2017 and 2021. Here, one of the models have outperformed the others or underperformed the others.
You could call it an exception... except that it happened 30% of the time!
The difference in performance is due to the reasons below:
In 2009, Model 1 underperformed, because it switches stocks faster and so it missed out on the upside, while model 2 and 3 switched less so they saw more significant gains.
In 2012, Model 3 underperformed because Midcap segment underperformed the rest of the market.
In 2017, Model 1 highly outperformed the others because of constantly switching stocks and sticking with winners.
In 2021 Model 3 outperformed because Midcap segment really outperformed the large and small cap market.
It sounds a bit random doesn't it? Well that's because it is. If you are riding the right horse, can you say it was just plain lucky.
How do you reduce the dependence on Luck? The answer is simple. Diversify.
The allocation of assets is your strategy. It is the only thing you can control and it reduces the role of luck.
So let's compare the returns over the years with some diversified models
1. Model 1 (50%) + Model 3 (50%) - Yellow marker
2. Model 2 (50%) + Model 3 (50%) - Light blue marker
This diversification strategy stabilises your portfolio so that you are not dependent on any single model to outperform. Your gains will stabilise over the years and you'll see a more steady CAGR figure which is closer to the target.
But before we conclude, let's talk a bit more about Diversification and its types.
Inter Asset and Intra Asset Diversification
The hybrid portfolios can also give negative returns. The underlying asset of both strategies is still Equity. This is called (my own definition) Intra Asset Diversification. The risk that your portfolio carries does not significantly reduce, and you have only guarded against the 30% cases of randomness.
True diversification, talked about by most people, is Inter Asset diversification. When you add Debt or Gold or Real Estate or some other asset to your portfolio mix, you have truly diversified across assets. These assets can significantly reduce the risk of your portfolio, though it could impact your returns a bit too.
Some would say that having your downside better protected is more valuable than higher returns. That's a tradeoff and we all can decide for ourselves.
Now that you have seen the help of 'Intra Asset diversification' for Equity Models from 2008 to 2021, let's try to apply the 'Inter Asset Diversification'.
Inter Asset Diversification for 'AlgoInvestors'
So, you have invested with us, using our Long only portfolio (Model 1, 2 or 3). You may feel that you have lost confidence in the market for sometime and you don't want to add more money to this portfolio.
But you still have investable money, which should ideally not be added towards more FDs.
Well then there is a proposition for you, the Nifty Long Short strategy.
It is a Nifty Index Futures based Long + Short strategy. That means it can generate returns whether the market goes up or down! This makes it an inter asset diversification.
You can read more about the strategy here.
Let's say you had invested in Model 1 + Nifty Long Short, below is how your returns would look like.
When the market goes up, NLS bets with the market, and when it starts falling it bets against the market. Nifty Long Short in itself is a high risk strategy and doesn't work well if the market is stagnant. You can see that in the graph from Feb to May 2021.
But in combination with Model 1, the results are live and there for you to see.
And if it's a little difficult to decide or complicated to decipher, give us a call.
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Appendix
The graphs you saw in the first section compare the model performance against each other in back testing. If you were wondering how they did when comparing with NIFTY50 and NIFTY MIDCAP then you can take a look at the graphs below. (Jan 2008 to June 2021)
Initial investment = Rs 100 in all the cases.
Happy investing!
Model 1 & 2 Back Test vs. NIFTY50
Model 3 Back Test vs. NIFTY MIDCAP
