How to Play This Volatile Market

Last Updated Sep 28, 2011 10:21 AM EDT

I get a lot of pressure to write about what the market is going to do in the short-term. Yet my competitive advantage as a writer and an advisor is that I know I don't know the answer. That is not to say I don't know the answer to earning more than just using the low-cost buy-and-hold diversified portfolio.

Last week, along with William Bernstein, I contributed to a column written by Jason Zweig for his Wall Street Journal Intelligent Investor column entitled, "Think Twice Before You Buy on the Dips." Unfortunately, you'll need to subscribe to the Journal to open it, but here's a video discussion:

The column notes that buying during dips isn't enough. In fact, over the past ten years, if you bought every time the stock market dropped two percent, you'd have made less money than just sticking to the buy-and-hold approach.

On the other hand, according to my calculations, if you just rebalanced once a year at the end of each year, you would have bested the buy-and-hold approach. Here are the annualized returns over the past 10 years on a portfolio of 60 percent stocks and 40 percent bonds:

  • Buy-and-hold: +4.9 percent
  • Rebalance at year end: +5.6 percent
Thus, the rebalanced portfolio earned 0.7 percent more annually. This may not seem like much but, for each $10,000 invested, it's an earnings difference of $6,203 vs. $7,104. I'll take this extra $901 any day.

The above calculations were made using 40 percent Vanguard Total Stock Index Fund (VTSMX), 20 percent Vanguard Total International Index Fund (VGTSX), and 40% Vanguard Total Bond Fund. I used the last trading day each year to rebalance so as not to pick dates using hindsight that would have produced even better returns. That would be cheating.

Extreme volatility of the past few years
I don't have to tell you that markets have turned extremely volatile over the past few years. After setting a record high in late 2007, stocks lost over 55 percent of their value. Earlier this year, they came within 1.8 percentage points of that record, only to give back about a third of that gain.

So to profit from this extreme volatility, investors would need to employ the one-two punch of buying after the plunges and selling after the gains. Thus, a better alternative to annual rebalancing would be rules-based rebalancing. By this I mean setting a tolerance trigger in your asset allocation. For example, were this to be six percentage points, rebalancing would be required if stocks become 66 percent or 54 percent of the portfolio.

Why this is so hard
While it's quite simple to rebalance, it's not very easy. Even financial advisors were heavy into stocks at the 2007 market high, only to turn to cash after the 55.2% decline. Though investors and advisors aren't buy and hold, they exercise poor market timing. Do you remember how hard it was to buy stocks in March of 2009 when the great depression ahead was in vogue? Funny, whenever stocks are on sale, no one seems to want to buy. But let them suddenly surge again, and investors are tripping over each other in their rush to buy.

Volatility is your friend
With supercomputers making thousand of trades a second and social media magnifying the herd effect, volatility is here to stay. That means more pain, yet with more pain comes more opportunity.

Remember that the media and short-term traders can create a ton of volatility that has very little long-term impact on shareholder value. Anyone brave enough to stick to their convictions, and by that I mean their asset allocation, and rebalance is likely to be playing this market right in the long-run.

And for most of the investors who will claim that they can do this, I assure you very few will be able to.

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    Allan S. Roth is the founder of Wealth Logic, an hourly based financial planning and investment advisory firm that advises clients with portfolios ranging from $10,000 to over $50 million. The author of How a Second Grader Beats Wall Street, Roth teaches investments and behavioral finance at the University of Denver and is a frequent speaker. He is required by law to note that his columns are not meant as specific investment advice, since any advice of that sort would need to take into account such things as each reader's willingness and need to take risk. His columns will specifically avoid the foolishness of predicting the next hot stock or what the stock market will do next month.