Gold prices jump as investors rush to safety - The Economic Times (Apr 13, 2020)

US gold prices hit a record high a year after Indian gold price hike - The Economic Times (Jul 27, 2020)

Gold prices today rise to Rs 51,600 on surge in Covid-19 cases – The Economic Times (Aug 31, 2020)

We have been reading these headlines ever since lockdown restrictions were imposed due to the Covid-19 pandemic. Gold prices have touched a new high of Rs. 58,000 (per 10g) in August 2020 (Gold rate as on 6^th Aug 2020; Source: MCX).

Will the current gold rush continue? While this is anybody’s guess, what it clearly highlights, time and again, is the herd mentality followed by investors. In the year 2020 till August 2020, there have been net inflows to the tune of Rs. 5,360 crores in Gold ETFs (See chart below, Source: AMFI) vis-à-vis outflows of Rs. 31 crores in the same period last year.

Herd mentality is generally seen when people start buying into a winning asset class (currently gold). However, investment decisions should never be based on following the herd or market noise but more on a defined asset allocation basis risk profile and investment horizon. Let’s understand this through an example.

Seema, Reema and Veena are 3 friends, who start their investment journey from 2006 with an initial corpus of Rs. 1 Lakh. While all of them invest in 3 asset classes (Equity, Debt, Gold), each follows a distinct investment strategy each year. Below is the calendar year performance of each asset class from 2006 to 2020 which we will refer to as “Winners Rotate”.

Seema tracks market movements of all asset classes and based on that year’s trend, she switches her entire corpus to the previous year’s winning asset class. E.g. In 2007, Seema invested her entire corpus in Equity since Equity was the top performer in 2006. She follows the strategy “Chasing the Winners.”

Even Reema tracks all market movements closely, however, she adopts a contrarian approach and follows “Chasing the Losers” strategy. She invests her entire corpus in the previous year’s worst performing asset class. E.g. In 2007, Reema invested her entire corpus in Debt since Debt was the worst performer in 2006.

On the other hand, Veena is not worried about chasing the “winners” or “losers” as she follows a “Diversification” strategy. She invests her entire corpus equally among all asset classes every year. She understands that winners rotate and investing across asset classes saves her the trouble of following market movements closely. She also rebalances her portfolio once every year such that any skewness in the allocation during the year is addressed and all asset classes have the same weightage at the beginning of the year.

The below chart shows the performance of each portfolio over the last 15 years:

From the chart, we observe that Seema’s portfolio which followed “Chasing the Winners” strategy remained an underperformer in 13 out of 15 instances which indicates one should avoid chasing the winning asset class by being a victim of herd mentality. However, this technique may work in the short-term (2006-2007, 2018-2020) but fails to generate meaningful returns over the long-term.

Reema’s portfolio which followed “Chasing the Losers” strategy outperformed the other 2 strategies in 8 out of 15 years. However, one may note that the volatility of returns (calculated using standard deviation) for this portfolio is the highest, among the 3 strategies.

On the other hand, Veena’s portfolio which followed a “Diversification” strategy could outperform only in 5 out of 15 years. However, the volatility of returns for this portfolio is the lowest, among the 3 strategies. Therefore, a well-diversified portfolio can provide better risk-adjusted returns over the long-term as compared to other strategies. While this strategy has delivered the highest returns over 15 years, it may not always be the case. Thus, a diversification strategy always aims for optimal returns and not maximum return at a relatively lower portfolio volatility.

To sum-up, here are 3 distinct takeaways for all investors:

1. Performance of each asset class varies over the years and winners keep rotating.
2. One must define an optimal asset allocation and stick to it no matter what the market noise is. Investors may consult a financial advisor to arrive at an optimal asset mix based on his/her risk appetite and goal horizon.
3. A diversified portfolio can earn better risk-adjusted returns as compared to a portfolio which is skewed towards a particular asset class.