Monday, 3 August 2015

Sell-offs don't pay off when markets fall

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?

Source: Vanguard

Rebalancing 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%.

An unrebalanced portfolio drifts from its allocation over time

Source: Vanguard

Emphasis on volatility

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.

Threshold rebalancing

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 goals.  

Peter Westaway is chief economist and head of investment strategy group at Vanguard Europe.