My take on the matter centers on this line of argument:
- Volatility is a factor intrinsic to markets and economies. They occasionally suffer steep plunges, so-called "corrections" in markets and recessions in economies, sometimes in concert, sometimes not. Between the drastic dives, they more commonly grow in a positive and orderly fashion. But the dives will happen, sooner or later.
- Predicting when they will happen, in advance, is hard. Maybe a few prescient souls can do it accurately for a while, but logically, if many of us could do it consistently, our collective actions would neutralize the effect or at least diminish it. We would be richer than we are.
- Although we can't predict in advance, we can respond intelligently after the fact. One rational response is to rebalance. As Andrew Ang explains in his fine textbook, Asset Management, rebalancing a portfolio is, for strictly mathematical reasons, a counterweight to volatility. One good way to implement a rebalancing strategy is to monitor your portfolio monthly or quarterly, and realign it to your target allocations if the overall percentage of stocks has drifted 3% to 5% from your objective. Another way is to invest at a low-cost firm like Betterment or Wealthfront that does so automatically. (Learn more by reading our article on rebalancing.)
- Additionally, volatility can be countered, somewhat, by investing in funds that specialize in finding low-risk stocks. Ang's book has more on this topic, and you'll find an overview in our article on factor investing.
To illustrate these ideas, consider the chart below. It shows three portfolios, all for the period from December 31, 2013, to January 20, 2016 (essentially, the last two years, up to the day before this post).
- Custom RB3% is a custom set of five low-cost mutual funds, rebalanced at the end of the month, if the portfolio's allocations drift by 3% from their targets. It was rebalanced twice previously, at the end of January and May 2015, and meets the criterion for rebalancing now.
- Custom RB5% is the same mutual funds, rebalanced monthly if the drift is more extreme, 5% or more beyond the target allocations. It was never rebalanced over the two-year period, but just now meets its 5% criterion for the first time.
- VSMGX is an all-in-one fund similar in composition to the custom fund. It has even lower costs than the custom portfolios, and is constantly rebalanced.
A second implication from the chart is about factor investing, which was the strategy used to select funds for the custom portfolios. Employing ideas outlined in two articles, Diversify! and Factor Investing (both on the Portfolios menu above), the custom portfolios consisted of:
- Vanguard Global Minimum Volatility (15%)
- iShares All-Country World Minimum Volatility ETF (15%)
- Vanguard Strategic Equity (15%)
- Vanguard U.S. Value (15%)
- Vanguard Long-Term Government Bond Index (40%)
Although both the custom and VSMGX portfolios have a 60-40 split between stocks and bonds, and both implement a rebalancing strategy, their results in the recent two-year period were quite different, as the chart illustrates. Don't jump to conclusions, however. Future years may turn out differently than the last two, and the usual cautions apply: Diversification does not guarantee a positive return; any investment strategy can lose money; and your results may differ from those depicted here. The ideas in this post are presented for information only and are not meant to endorse a particular firm or security. Please read our full disclosures.