Over the last two months, equity markets have recoiled, losing more than 10 percent in the broad indexes. So far in 2016, stock market swings and volatility have been the norm, which can be troubling for investors.
The impulse to act can lead to mistakes and mismanagement of investments. Selling during periods of weakness in the market creates a guaranteed loss. The trouble for retail investors and professionals alike is that trying to time the market during rough periods can further compound losses in their portfolios.
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This can keep you on the sidelines when the market recovers, which can happen in a matter of days.
Deploying an asset allocation and rebalancing strategy can provide a playbook for investors to combat volatility and help them make challenging investment decisions in both good and bad markets.
When utilizing an asset allocation investment strategy, you apportion a percentage of your investment portfolio to certain asset classes, balancing risk and reward based on factors such as time horizon or risk tolerance.
Oftentimes, people speak of asset allocation in terms of assigned percentage, such as 60/40. This refers to the percentage allocated to stocks and bonds — in this case, 60 percent to stocks and 40 percent to bonds.
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The purpose of asset allocation is to provide a balanced investment approach in most markets and to combine two low correlated investment categories, such as stocks and bonds, which often do not move in tandem with one another.
There are several different types of asset classes that fall into each category. For example, in the stock category, money can be apportioned to large-, mid- and small-cap U.S. equities, international developed markets, emerging markets and real estate.
Bonds are just as nuanced, including U.S. government, corporate, high-yield and foreign bonds. Asset allocation also assigns risk within stocks and bonds, allocating a percentage to each asset class.
In most allocation models, you will find the highest percent of allocation to large U.S. stocks and high-quality bonds, as they tend to be the most stable within their respective categories. Asset classes, such as small-cap stocks, emerging market stocks and high-yield bonds, which tend to be more volatile, would have a smaller percentage of the allocation.
“Investors often find themselves … selling the weak asset classes and buying strength — bonds in bad markets and stocks in good markets.”
This now brings us back to rebalancing. The concept is to sell strength and buy weakness to get back to your allocation model.
Adhering to a systematic rebalancing approach to bring the percentage invested back into alignment allows investors to avoid the game of trying to time the market. So far this year, emerging market stocks (as measured by the MSCI EM index) have been the biggest loser, down 9.20 percent.
In general, bonds have performed better than the equity markets. Rebalancing the portfolio by selling some percentage of bonds, perhaps as small as 1 percent or 2 percent, and adding to emerging market stocks fits right in line with the “buy low, sell high” mantra.
Moving from bonds to stocks and stocks to bonds over market cycles can add as much as 1 percent per year to performance in published studies.
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Keep in mind, rebalancing can also occur within an asset category. This also answers the age-old question “What do I do?” when the stock market appears to be swooning.
Investors often find themselves doing the opposite, selling the weak asset classes and buying strength — bonds in bad markets and stocks in good markets. This has the opposite effect on the performance of the portfolio.
There are two major ways to take action regarding your rebalancing strategy. The most popular is setting a threshold for each asset class, such as 10 percent to 20 percent relative to the movement of the target allocation. Once an asset class moves into the relative zone, the investor will make trades to rebalance.