If markets are good at one thing, it’s reminding investors that stock prices don’t simply go up, uninterrupted, forever. I have updated this report several times since it was initially published in 2008; it’s undoubtedly obvious why I’m doing so again. I do not have a crystal ball and they don’t ring a bell at market tops or bottoms. It’s not what we know, or you know, about the future (path of the stock market) that matters. It’s what we do along the way that matters.
Markets do drop. Bear markets arrive. That’s an unavoidable part of investing. What matters is how you respond. If you’ve built a portfolio that is directly tied to your time horizon and risk tolerance when markets are calm, then a surge in turbulence may not leave you shaken. Good planning, and discipline along the way, is like a pre-emptive dose of Dramamine—it can help neutralize some of the nausea before the turbulence hits.
Panic and greed
When it comes to panic, the most obvious example is trying to dump investments when the market is dropping. This is a great way to invert the old adage about buying low and selling high. Never before has information about the economy and markets been more readily available and disseminated; and never before has it been easier (and less expensive) to trade. As a result, our reaction mechanisms are heightened—but not necessarily to our advantage.
Greed can also lead us astray in a number of ways. First, there’s the temptation to load up on aggressive higher-risk assets in the hope of a big payoff. But there is a dark side to an aggressive posture’s potential higher returns: the risk taken in getting there. Aggressive portfolios’ higher historical returns have had a much wider range of returns—that is, a higher standard deviation, with greater “drawdowns,” or peak-to-trough declines, and volatility. And most importantly, those higher returns typically are generated through “stick-to-it- iveness,” not lucky bets.
Then there’s the temptation to try to “time” markets. It’s enticing to try to catch the next big investment wave (up or down) and allocate assets accordingly. But there are very few time-tested tools for consistently making those decisions well.
It’s also important to consider how the two impulses can work together, with yesterday’s greed paving the way to today’s panic. Investors may think they understand their risk tolerance—until they don’t. There’s a big difference between financial risk tolerance (the ability to financially withstand volatile markets) and emotional risk tolerance. The gap between the two is often quite wide and typically becomes evident in tumultuous market environments.
Relying on the rearview mirror
Too often, investors use a rearview mirror to make investing decisions, treating past performance as a guide to future results. I’ve known plenty of older, close-to-retirement investors who have stuck with their aggressive investment stances because they were accustomed to the thrill—with little fear about how a loss at the start of retirement might affect their savings. I’ve also known plenty of young investors who couldn’t stomach the thought of any meaningful drawdown, despite having many decades in which to potentially recover and accumulate returns.
Many aggressive investors have learned the hard way that they had a lower tolerance for a big loss in the short term than they thought. And to maintain their aggressive allocations via rebalancing, they generally had to double down on the asset classes that generated those steep losses and shift away from the asset classes that had weathered the storm.
Conservative investors should heed the lesson, as well. A conservative portfolio’s lower historical returns have come with significantly less-severe drawdowns and volatility. For some, the lower return is worth the sleep-at- night benefits. But the reality is that many investors want all of the upside when markets are performing well, but none of the downside when they are not. That is highly unrealistic.
I often talk about the beauty of periodic rebalancing as an essential investing discipline. Maintaining your target asset allocation by adding to underperforming asset classes and trimming outperforming ones—goes against the emotions of fear and greed that often drive investment decision making.
It may be challenging to sell investments that have done well and add to holdings that have underperformed, but developing and maintaining the right long-term asset mix is by far the most important set of decisions an investor will ever make.
Rebalancing forces us to do what we know we’re supposed to do, which is “buy low, sell high” (perhaps better thought of as “add low, trim high”). Importantly, the absence of a rebalancing strategy can get otherwise-disciplined portfolios out-of-whack.
The chart below looks at two periods to illustrate the peril of not rebalancing and uses a very simplistic portfolio allocation of 60% equities and 40% bonds (60-40) starting in 2007. Absent rebalancing on an annual basis, the allocations would have swapped places by 2009, leaving investors ill-positioned to benefit from the multi-year equity market recovery that ensued. In turn, a 60-40 portfolio in 2009, without rebalancing, would have morphed toward a 90-10 portfolio by the beginning of 2022. Given the bear market underway this year, the pain differential is significant between 90% equities and 60% equities at the start.
A theme of our advice over the past year or so is for investors to consider volatility-based rebalancing vs. calendar-based rebalancing. Taking transaction costs, tax implications, and other considerations into account, investors can “stay in gear” with market moves by rebalancing based on volatility’s impact on portfolio allocations.
The closest thing to a “free lunch”
Admittedly, the development of a long-term strategic asset allocation plan isn’t the hard part—it’s sticking to it that often becomes the real challenge. That can be especially difficult when markets are volatile. But if we learn from our mistakes, use our brains over our hearts and look to our portfolios as rebalancing guides, we can expect a more successful investing future and maybe even get a free lunch along the way.