The evidence suggests that a long-term, strategic approach to investing generates the most attractive returns for investors over time. But we all—advisors and investors, alike—can get nervous, leading us to make impromptu readjustments to portfolio allocations during periods of market volatility, which is often the worst possible time. And with a contentious presidential election coming up, worries about market reactions are more top of mind than ever.
What can you do to help position your clients' portfolios to better withstand future volatility? Here are three rebalancing strategies that can be beneficial over time.
Strategy #1: Buy and Hold
Rebalancing is often thought of as a return enhancer. In fact, it should probably be thought of as a risk reducer, particularly for those investors who employ a buy-and-hold approach.
Without a rebalancing strategy, a balanced equity (e.g., 60/40 stock/bond) portfolio would experience an increase in risk for every month, quarter, or year of equity market appreciation. This is because the equity portion would continue to grow and compound in size relative to the fixed income allocation—potentially ending up somewhere close to a 70/30 or 80/20 portfolio after a period of strong equity market appreciation. As a result, a balanced equity profile would actually take on the risk profile of a more aggressive allocation, possibly leading to a compliance red flag. This is considered a simple buy-and-hold strategy, for obvious reasons.
Strategy #2: Constant Mix
This is a dynamic or "do-something" strategy. This tactic lends itself well to volatile periods, such as the one witnessed post-financial crisis, because the investor rebalances to an increased equity weight in periods of weakness and sells after periods of strength (buy low, sell high). This is the simplest form of rebalancing—and the one employed by many individuals across the industry. It also ensures that the risk profile for a portfolio is generally constant through time, as the mix between equities and fixed income doesn't drift too far from the strategic weights. Here, you can see the value from a risk reduction standpoint.
As most market environments are characterized by oscillations, practitioners usually opt for a constant-mix strategy. Also, when entering risk into the equation, it's viewed as the most prudent of the rebalancing options.
Strategy #3: CPPI
One of the most underutilized—though effective—rebalancing strategies is known as constant proportion portfolio insurance (CPPI). A bit more complicated than the other options discussed here, this method includes a floor value, a multiplier, and the use of two asset classes: risky asset (equities) and lower-risk asset (cash or Treasury bonds). To illustrate how it works, let's look at an example.
The investor decides to allocate $100 to a portfolio and denotes $75 as the floor. The allocation to the risk asset at inception is determined by the multiplier times the difference in the portfolio value and the floor. Here, let's assume a multiplier of 2:
- The allocation to equities would be 2 × (portfolio value – floor) or $50 at inception.
- If markets decline over the next year and the portfolio level reaches $95, the investor would rebalance the equity portion to $40 (2 × [$95 – $75]).
If fear grips the market and the portfolio drops to the floor, the investor would allocate all proceeds to the lower-risk asset, such as Treasury bonds. As a result, the stock allocation will be dynamic and will increase (decrease) along with the appreciation (depreciation) in stocks at a faster pace than would a simple buy-and-hold strategy. The main difference between the two strategies is the multiplier and the incorporation of a floor value, also called the insurance value.
As you may realize, this strategy can be most effective in strong bull markets, like that of the late '90s, where each successive increase in equities results in the purchase of more shares. In severe bear markets, the strategy can provide downside protection because the floor value insulates and provides insurance against large declines in value. Oscillating markets and those characterized by severe short-term reversals, however, can wreak havoc on a CPPI design. As a result, its return payoff is the opposite of that of a constant-mix strategy.
Which strategy should you choose? To help illustrate when you might implement each of these options, the chart below outlines the types of environments that may be suitable for each strategy.
