3 Ways to Make Market Volatility Work For You
February 15, 2016Does the recent market volatility make you afraid to look at your 401(k) statement? Maybe it’s time to think about adopting a portfolio rebalancing strategy. Rebalancing is the process of periodically selling or buying investments in your portfolio in order to maintain your target mix of investments over time. It helps you keep the level of risk in your portfolio stable by taking some profits from those funds that are now taking up more space in your portfolio than originally intended – usually because they grew in value – and buying more of the funds that are now taking up less space than you intended, possibly because they fell in value. Since stocks, bonds and other investments tend to move up and down at different times, implementing a regular rebalancing strategy with a diversified portfolio mix helps you “buy low, sell high” over the long haul.
Let’s say you were going to take a vacation in Europe. You’d plan your itinerary in advance, choosing which countries you’d like to visit, what sites you’d like to see, how you’ll get there, how much you plan to spend, etc. When you actually go on your trip, you may find that things change along the way that cause you to adjust your plans – a delayed flight, lost luggage, bad weather, etc. Then you have to adjust.
Investing is the same. First you put together your itinerary, called “asset allocation” in investment jargon. Asset allocation is how you split up your savings between different types of investments such as stocks, bonds, real estate and commodities. By diversifying your investments, you minimize the risk that they will all fall in value at the same time.
Don’t have an asset allocation strategy? You can use this calculator to develop a basic strategy and this worksheet to put together something more detailed. Once you’ve begun your investing trip, you may find that there are unexpected detours along the way like a stock market downturn or interest rates cuts that cause a bond rally. Here are three ways to rebalance your investment mix to get back on track:
1. Rebalance According to the Calendar
With calendar rebalancing, you pick a regular date where you will rebalance your investments to their target weights. Sell enough of what’s gone up to get back to the target weight, and buy more of what’s gone down. You could do this monthly, quarterly, semi-annually or annually, but don’t forget to do it at regular intervals over a long period of time. Calendar rebalancing is generally combined with trying to maintain a constant mix of investments, for example 65% stocks/35% bonds.
2. Percentage of Portfolio Rebalancing
Not sure you want to rebalance that strictly? Percentage-of-portfolio rebalancing involves setting a tolerance band stated as a percentage of the portfolio’s value. When an investment falls below or rises above the tolerance band, it triggers rebalancing back to your target asset allocation for the entire portfolio.
For example, a 40% weighting in bonds with a +/- 5% tolerance band means that bonds could make up between 35% and 45% percent of the portfolio without rebalancing. If they rise to become 46% or fall to 34% of the portfolio, that triggers rebalancing of all the investments back to their target percentages. It’s best to do some research when setting the tolerance band. Too narrow means normal market volatility will lead to excessive rebalancing and too wide makes it easy to take on extra risk. You’ll also need to check the percentage weights at regular periods to see if the need to rebalance is triggered.
3. Constant Proportion Portfolio Insurance (CPPI)
Do you have an amount below which your portfolio must not fall? Consider a constant proportion portfolio insurance (CPPI) rebalancing strategy, where stock holdings are held to a constant proportion of the predetermined cushion – the difference between the total portfolio value and the floor value:
Target investment in stocks = target proportion × (current portfolio value – floor value).
CPPI rebalancing is expected to do well in bull markets, when the increasing cushion leads to purchasing more stocks. It could also be helpful in bear markets because when the cushion is zero, there are no holdings in stocks. In a volatile market with frequent reversals of short term trends, however, CPPI tends to underperform.
What’s the best rebalancing strategy for your retirement journey? It depends on your risk tolerance, how “hands-on” or “hands off” you are with your investments, and whether you have perseverance to stick to it consistently over a long time period. Check with your 401(k) provider. Many have automatic rebalancing options available or offer fixed asset allocation funds where the rebalancing is done for you.
How about you? Do you have a personal finance question you’d like answered on the Monday blog? Please email me at [email protected] or follow me on Twitter at @cynthiameyer_FF.