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Profiting from Volatility

By: Frank Armstrong

By: Frank Armstrong, III, CFP, AIFA®

Volatility in the world’s investment markets is a disconcerting fact of life. But, little as investors like it, volatility has a silver lining. A simple strategy of re-balancing your portfolio as the various parts vary may pay handsome dividends.

We know several things about the world’s equity markets:

  • Over time they have a strong upward bias.
  • In the short run they may be volatile. For all practical purposes these movements are random and therefore unpredictable.
  • They don’t go up forever (think tech and S&P 500 in the late 90s).
  • They don’t go down to zero (unlike single stocks like Enron, or Lehman).
  • They often move in different directions (low correlations) or different velocities.
  • Over the long haul, they outperform fixed income, but have higher volatility.
  • They exhibit a strong tendency to revert to the mean.

So, if you had a diversified global portfolio divided between equity and fixed income and the equity portfolio was further divided into 8 or 10 distinct markets with fixed allocations you might often observe the various parts bouncing around like so many crazed ping pong balls. Given the calming effects of diversification, the portfolio as a whole bounces less than its parts.

The random bouncing of the various parts is a good thing. It gives us the opportunity to systematically rebalance back to an appropriate target asset allocation as your portfolio fluctuates. This enhances total return while moderating risk. Rebalancing forces a policy of selling high and reinvesting the proceeds into underperforming markets. When a particular market soars, we take some of the gains off the table. When a segment underperforms, we augment our position there. Someday they will change places. When they do it provides us with an incremental gain over a strategy that doesn’t rebalance.

During periods when the various market segments move together, there is no opportunity to rebalance. For maximum benefit we would like to see the various segments bouncing a lot relative to each other. The lower the correlation between fixed income and equities, and/or between the various parts of the global equity markets, the higher the benefit to the portfolio.

For the strategy to work effectively, markets must continue to revert to the mean over time, and the world must not end. We expect both those conditions to be met. There is credible economic theory to support mean reversion, and after each financial crisis we have always muddled through our problems and eventually returned to a growth trajectory. This time it’s not different!

For maximum effectiveness the strategy should be exercised opportunistically and dynamically rather than on a fixed interval. Opportunities to profitably rebalance might be lost if the portfolio was only examined once a year. Suppose an asset class were to double during the first six months of the year, and then shrink back to its starting value at the end of the year. The chance to make a very profitable trade would have been missed. So, we monitor the portfolios and trade whenever an asset class moves out of a predefined band. The band must be wide enough to avoid daily or trivial trading, and small enough to capture valuable opportunities (net of all costs for execution and taxes).

Frankly, this strategy is counterintuitive. It may disconcert some investors who can’t relate to selling the “good” performers and buying the “bad” performers. But, we can demonstrate that it adds considerable value over time.