Originally written on 19th June 2013
Interesting chart on yearly and
10 year cumulative return delivered by different Asset Classes…..the exhibit
underscores one often touted characteristic of the markets…That it is nearly
impossible to predict the best performing or for that matter the worst
performing asset from one year to next (Remember, safer and less volatile
assets are usually at the bottom in return ranking, but that does not mean that
you can predict their outperformance or underperformance relative to riskier
asset classes from year to year). A equally weighted allocation across all
asset classes as represented by the ‘Asset Allocation bloc (in Grey) is one
best method to both remain reasonably well diversified and making sure your
portfolio does not end up at the bottom (but will also preclude its possibility
of ending at the top). A second observation, is that asset classes
(particularly risk asset classes) that performs worst on relative basis in
given year(s) usually has a higher probability of outperformance in subsequent
period(s). Hence a strategy of buying losers and selling winners may result in
long term outperformance.
Below i present a mechanical asset allocation strategy
that:
1. Invest in the subsequent year in the best
performing asset of the previous year (eg. invest 100% in MSCI EME in 2004
after the asset class being best performing in 2003)
2. Invest in the subsequent year in the worst
performing asset of the previous year (eg. invest 100% in Cash in 2004 after
Cash being the worst performing asset class in 2003)
3. Invest in three best performing assets of any
given year in subsequent year on an equally weighted basis (eg invests in MSCI
EME, Russell 2000 and MSCI EAFE in 2004 on equally weighted basis)
4. Invest in three worst performing assets of any
given year in subsequent year on equally weighted basis (eg invests in Cash,
Barclays Aggregate bond index and Market Neutral in 2004 on equally weighted
basis)
The results of
this exercise tabulated below are rather interesting, The contrarian strategy
of holding worst performing assets in subsequent period is more than twice as
profitable than the strategy of holding the best performing assets. Secondly,
on risk adjusted basis, the sharpe ratio of the contrarian strategy is better
than that of the momentum strategy. Thirdly, the portfolio model (three best
and three worst) approach is more superior than holding 100% of single asset in
both absolute return and risk adjusted return terms.
2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

Cumulative
Return

Std Deviation
of Return

Maximum
Drawdown

Sharpe Ratio


Best performing
asset previous year

1.26 
1.12

1.33

0.84

0.47

1.06

1.19

1.08

1.20 
20.8% 
26.2%

53%

0.79


Worst performing
asset previous year

1.01 
1.03

1.04

1.16

0.62

1.79

1.00

1.05

1.19 
74.8%

30.5%

38%

2.45


Three best
performing assets classes in previous year (Eq wt)

1.22 
1.20

1.21

1.12

0.56

1.03

1.18

0.95

1.08 
39.6%

20.8%

44%

1.90


Three worst
performing assets classes in previous year (Eq wt)

1.04 
1.04

1.09

1.09

0.79

1.47

1.02

1.04

1.12 
76.6%

17.4%

21%

4.39

I have highlighted the year 2007,
2008 and 2009 to draw special attention to another interesting observation. As
one would notice, the previous year best performing asset and equally weighted
portfolio usually have a return in double digit whilst the worst performing
asset and portfolio of worst performing assets has a low single digit return in
most periods. So why does the worst performer come out best over the 10 year
period?
The answer lies in 1) the sharp
volatility of best performing but more riskier assets such as MSCI EME index
(compare Maximum Drawdown statistics). The best performing assets after three
years of double digit return were cut into less than half in the financial
crisis of 2008/09 while the worst performing asset of 2007 were trading at a
depressed valuations going into 2008 and logically were relatively less
impacted. Also the worst performing asset of 2008 were grossly undervalued
going into 2009 due to duress in the market at that time (having being
cut in half or less in just one year time) and hence recovered sharply in the
subsequent year.
So what lesson does the above study holds for an average
investor?
1) Not losing money is more important than making
money due to the power of compounding (see the compounded performance of best
and worst performing assets between 20042009). Every dollar invested in best
performing asset and rebalanced annually was worth only 21 cents in 2009
despite three years of double digit growth. On the other hand, every dollar
invested in the worst performing asset in 2004 was worth 41 cents in 2009 twice
as much as its counterpart
2) Dislocation in asset prices due to duress in the
market can be good time to accumulative worst hit assets as prices are riddled
for reason other than the long term earning capacity of the asset and investor
outlook on valuations of such assets is at the nadir. Such dislocation provide
opportunity to earn excess return in subsequent periods while valuation recover
back to its historic average. This strategy is also safer as reflected in
maximum drawdown and sharpe ratios.
END
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