Ian Green. This is my blog where I talk about my work in financial services as well as other bits and bobs from my life. The idea is that prospective and existing clients can read more about me, what I do and how I do it. You can view my website at www.iangreen.com where you can also find how to get in touch.
Don't panic! Sell-offs
don't pay off when markets fall
The recent rumbling in the bond markets is a
reminder that investment risk is far from a thing of the past. Combined with
the volatility inherent in equity markets, it is worth investigating further my
mantra of ‘time in the markets, not timing the markets’.
The remainder of this
article has been written by Peter Westaway, chief economist and head of
investment strategy, Vanguard Europe
Rather than trying to call the market, yet again,
time might be better spent considering the right and wrong ways to manage the
impact of market turbulence on an investment portfolio.
The temptation, which can seem intuitively
powerful, is to adjust a portfolio in response to events or trends perceived in
the market. But data show the opposite is often right: investors are typically
better served by ignoring market noise and maintaining their original asset
allocation through a disciplined rebalancing schedule.
The best approach, in my view, is to embed
portfolio rebalancing into an investment plan at the earliest stage,
emphasising that the purpose is not to maximise returns but to manage risk.
What if the
drifting investor fled from stocks after the 2008 plunge?
racks up returns
A sterling investor who maintained a (hypothetical)
portfolio of 60% global equity and 40% global bonds through the whole of the
last market cycle, from 31 March 2003 to 31 December 2013, rebalancing twice a
year, would have had a cumulative return of 140%.
An investor who switched out of equities at the
bottom of the market, in January 2009, far from saving themselves or their
capital, would have reduced their cumulative return for the full period to 86%.
Looking at a 60/40 portfolio over the longer term
produces some interesting results when comparing a portfolio that is rebalanced
with one that is not. Over the period 1960 to 2013 a portfolio rebalanced
annually returned slightly more, 10.35% compared with 10.08% to one that was
not rebalanced. But the volatility, as measured by standard deviation, was
significantly less in the rebalanced portfolio, 19.7% against 21.97%.
portfolio drifts from its allocation over time
A simplistic interpretation of this result would be
that the value of rebalancing is 0.27 basis points (bps): 10.35%-10.08%. This
would be a misleading measure, however, mainly because the sign of this effect
could be positive or negative, and on average it is likely to be negative. On
the basis that rebalancing is about managing risk, the emphasis should be on
the difference in volatility.
A portfolio with a similar long-term risk profile
as an unbalanced 60/40, using the same portfolio constituents as above, is
close to a rebalanced portfolio 70% equity and 30% bonds, the annualised
volatility of these two portfolios being 21.67% versus 21.97% respectively.
Over the same period, 1960 to 2013, the 70/30 portfolio returned 10.51%, a full
43bps more than the unrebalanced 60/40. Under these assumptions, the value of
rebalancing can be assessed at 0.43% per annum.
The above example uses a simple time-only
rebalancing strategy but more sophisticated approaches are also possible. A
time-only strategy will rebalance on a given date, regardless of the relative
performance of the portfolio’s component assets. In a threshold-only strategy,
rebalancing is triggered when a portfolio’s asset allocation has drifted by a
given amount, regardless of how often this happens.
A strategy combining the two will monitor the
portfolio on a given schedule and have pre-set thresholds, but rebalancing will
only occur when the two trigger points cross. Over the long term, the data show
the optimal time-and-threshold strategy is probably to monitor the portfolio
annually and to make adjustments when the drift is 5% or more, bearing in mind
that rebalancing attracts costs and taxes.
The precise value of rebalancing will always depend
on the behaviour of the markets and the nature of the assets in the portfolio,
as well as costs. Those who maintain disciplined rebalancing through episodes
of exceptional volatility will tend to gain most. But the key issue is that a
rebalanced portfolio is one that remains focused on the investor’s
Peter Westaway is chief economist and head of
investment strategy group at Vanguard Europe.