Harnessing the Stock Market's Natural Rotation
Harnessing the Stock Market’s Natural Rotation: An Asset Allocation Strategy
“Historically, overweighting the in-favor style and underweighting the out-of-favor style would have resulted in higher returns than investing in the broad market.”
Rick Golod, Director of Global Investment Strategies, Invesco
Asset allocation strategies have continued to evolve since Harry Markowitz pioneered the concept of Modern Portfolio Theory (MPT) in 1952.
As a consequence, the standard 60% stock/40% bond portfolio of yesteryear now includes other asset classes such as international equities and debt, real estate, commodities, currencies, private equity and the more contemporary “liquid” alternatives such as mutual, exchange-traded and closed-end funds.
In theory, diversifying a portfolio across asset classes and investment styles should help reduce the overall volatility and smooth returns long term. However, the recent GFC exposed a considerable flaw in the application of MPT.
This problem is especially true in the US equity market, where investor portfolios tend to be diversified with nine standard style categories, covering large-, mid- and small-caps, and value-, growth-, and blend-oriented stocks. However, these styles typically have high correlations with the S&P 500 Index.
It’s also worth noting that the equity market has historically tended to follow a natural rotation pattern. Although past performance is no guarantee of future results, this strategy has worked 77% of the time in the past 35 years.
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Frequently Asked Questions about this Article…
The natural rotation in the stock market refers to the historical pattern where different investment styles, such as value, growth, and blend, come in and out of favor over time. This rotation can impact the performance of various asset classes and investment strategies.
Investors can benefit from the stock market's natural rotation by overweighting investment styles that are currently in favor and underweighting those that are out of favor. This strategy has historically resulted in higher returns compared to investing in the broad market.
Modern Portfolio Theory (MPT), pioneered by Harry Markowitz in 1952, is a framework for constructing a diversified investment portfolio to maximize returns for a given level of risk. It emphasizes the importance of asset allocation across different asset classes to reduce volatility and smooth returns over the long term.
Diversification is important because it helps reduce the overall volatility of an investment portfolio. By spreading investments across various asset classes and styles, investors can potentially achieve more stable returns and mitigate risks associated with any single investment.
Contemporary asset classes in modern portfolios include international equities and debt, real estate, commodities, currencies, private equity, and liquid alternatives such as mutual funds, exchange-traded funds (ETFs), and closed-end funds.
The Global Financial Crisis exposed flaws in Modern Portfolio Theory by highlighting that even diversified portfolios can experience significant losses during market downturns. This is particularly true when asset classes that are supposed to be uncorrelated move in tandem, as seen in the US equity market.
The nine standard style categories in US equity markets include large-cap, mid-cap, and small-cap stocks, each further divided into value, growth, and blend-oriented styles. These categories help investors diversify their portfolios across different segments of the market.
While past performance is no guarantee of future results, the strategy of following the stock market's natural rotation has worked 77% of the time over the past 35 years. This suggests a relatively high level of reliability, though investors should always consider current market conditions and their own risk tolerance.
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