Warren Buffet once said: “Be Fearful When Others Are Greedy and Greedy When Others Are Fearful”, so how can we implement his contrarian investment philosophy? How can we combine it with our sector rotation strategy?
First we need to know when the average investor is fearful and when he is greedy, for this purpose we will look at the average investor’s equity allocation, when investors are fearful they tend to allocate more to bonds, treasuries, and cash when they are greedy they tend to risk more on equities.
Average investors equity allocation= Equity/(Bond+Treasuries+Cash)
When we look at the attached graph we can see that in times when investors were very greedy like in late 90`s there equity allocation went above 0.5 (more than 50% in equities) ,this over optimism condition was followed by major market crash, on the opposite in times when investors were very fearful like in the bottom of the 2008 crash the equity allocation was about 25% this was the start of a major bull market which still lasts today. So if we want to take a contrarian approach to improve our risk adjusted return we can allocate equity in an opposite way . Here is a simple way for choosing your allocation:
Equity weight=(1-Investors equity allocation)*Risk-Preference
- Risk-Preference for Aggressive allocation is ~1-1.2
- Risk-Preference for Moderate allocation is ~0.5-1
- Risk-Preference for Conservative allocation is ~0.25-0.5
- For example equity weight for aggressive portfolio today =(1-0.4)*1.2=72% the left 28% is held in Treasuries +Bonds +cash.
How we combine it with our sector rotation approach? In times when our sector rotation market timing is invested in sector equities we do not invest 100% of our portfolio in equities but rather use this model. In times when our market timing indicates bearish market conditions this model is not relevant we go 100% to cash and treasuries.