How does mean reversion affect investor returns?

Photo: Mint

FY21 is ending with a close to 70% rally in the Sensex, almost zero return for gold, and 5-6% returns on fixed deposits, many of which are tied to the pandemic. Investment return expectations should factor in long-term returns, because of mean reversion. Mint explains.

What drove asset returns in FY21?

FY21 began as India was hit by the first wave of the pandemic. The country went into lockdown and the stock market crashed. As the disease slowed in the second half of the year, the economy was opened up again. Easy monetary policies in developed nations resulted in around $37 billion in foreign institutional investment (FII) flowing into India’s stock market and it rebounded. At the same time, the RBI undertook its own monetary easing, causing interest rates, and hence FD returns, to dip. Practically every asset was affected by the macroeconomic dislocations caused by the pandemic.

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Practically every asset was affected by the macroeconomic dislocations caused by the covid-19 pandemic

What is mean reversion?

Mean reversion is the idea that asset returns converge to their long-run level and short-term extremes get ironed out. Hence a one-month or even a one-year return of an asset should not be extrapolated, particularly if it is very different from the long-term average. The Sensex has rallied around 70% in FY21. But this return taken in isolation is misleading as the fiscal year began with a market crash. Much of the rally was fuelled by easy monetary policies, but this may not continue indefinitely. Yields have begun rising in the US, and this has brought down the return on gold and increased volatility in stocks.

What determines long-term investment returns?

These are usually determined by long-term macroeconomic factors such as gross domestic product (GDP) growth or interest rates as corporate earnings are ultimately linked to GDP growth. However, long-term returns are not static and can change over time such as the multi-decade fall in interest rates around the world.

Should you look at rebalancing portfolio?

Yes, experts tend to suggest these shifts when unusual market moves happen. Assume that your long-run portfolio considering risk appetite and time horizon is 50% equity and 50% debt and because of a rally in the equity market, the equity percentage rises to 60%. You can sell off the excess equity and invest in debt mutual funds to bring it back to 50:50. However, if you see that an asset has underperformed massively in a particular year you can consider increasing your allocation to it.

What are the costs of rebalancing?

Sometimes assets come with lock-in periods. Thus, an investor cannot move between these assets. For example, equity linked savings schemes, or ELSS, mutual funds have a three-year lock-in period. Bank FDs can be broken. However, breaking these FDs usually attracts premature termination penalties. Mutual funds have exit loads for short-holding periods. Another cost of rebalancing is that it tends to attract tax. Selling of equity can mean realising capital gains and hence the investor may have to pay capital gains tax.

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