Volatility and the Rebalancing Strategy

Volatility and the Rebalancing Strategy - 25 Sep 2011 “Volatility and the rebalancing strategy”, featured in Money, Life & Times, New Sunday Times, on 25th September 2011. From Aug 1 to Sept 6, the American market was down eight per cent, the Hong Kong market was down 13 per cent and the local market was down 6.6 per cent. It was a scary experience for a lot of investors. However, it we truly believe in the golden investment principle of buying low and selling high, we should grab the opportunity to buy low now. As an independent financial advisor, I try to help my clients adhere to this investment principle despite their fear. I believe that if my clients were to invest in quality investments at a low price now and hold for a few years, they will stand to gain handsomely later. So, I have been trying to encourage them to invest their money. Most don’t feel comfortable investing a lump sum. Therefore, I suggested that they invest on a staggering basis for the next few months (I wrote about the dollar-cost averaging strategy and my experience in this column in Aug). Some clients followed my advice while others prefer to wait before taking action. I believe many readers of this column may fall into the latter category. If you are too scared to apply the dollar-cost averaging strategy, I have another strategy where you can profit from the current market volatility – the rebalancing strategy.
The theory
Before we look at how to apply the rebalancing strategy in the current market scenario, I will explain how it applies under normal circumstances. Rebalancing is a strategy and discipline to maintain the same percentage in various asset classes (equity, bond and cash) in your investment portfolio. In proper investment planning and management, your job does not end when you finish structuring your asset allocation. Different asset classes will perform differently as time goes by. We need to review and rebalance our investment portfolio regularly to ensure that our strategic allocation remains in place and is relevant. Generally, equities will perform better than other assets in the long run. As a result, it is very likely that your equity asset class will grow faster than the bond and cash asset classes. If you do not review and readjust the portfolio, the equity asset class will gradually form a bigger part of your portfolio and deviate from your original asset allocation. At Whitman, we recommend a client to do the rebalancing strategy at least once every six months or when his or her portfolio changes for more than 10 per cent. Below is an example which explains the rebalancing strategy:
Table 1
This portfolio starts with 20 per cent in cash, 30 per cent in bond and 50 per cent in equity. At the end of six months, cash asset class fell from 20 per cent to 17 per cent and bond asset class fell from 30 per cent to 26 per cent. In the meantime, equity holding increased from 50 per cent to 57 per cent of the overall holdings. According to the rebalancing strategy, you will need to rebalance your investment portfolio if your investment risk tolerance remains the same. What you have to do is sell some of your outperforming asset class and use the proceeds to buy more under-performing asset classes.
Table 2
Based on the figure in Table 2, you would need to sell RM167,000 worth of your equity to buy RM69,200 worth of cash and RM97,800 worth of bond to return to the original asset allocation percentage. This is not an easy thing to do because you need to sell off the asset that has given you the best return to buy more of the assets that have under-performed. However, if we want to stick to the strategic asset allocation and maintain our risk tolerance, that’s exactly what we must do. In addition, when you rebalance your investment portfolio, you actually apply one of the most important investing strategies to buy low and sell high. By rebalancing your portfolio on a regular basis, you have automatically incorporated this strategy in your programme. When you do rebalancing, you will sell those investments that have become higher priced and buy those investments that have become lower priced.
Profiting from current market
Now, let’s see how we can apply the rebalancing strategy in the current market scenario assuming that you hold an investment portfolio like the following example:
Table 3
Table 3 is an example of how the value of that investment porfolio changed during August 2011. This portfolio starts with 30 per cent in bond and 70 per cent in equity. At the end of August, bond asset class grew from 30 per cent to 35 per cent. In the meantime, equity holding fell from 70 per cent to 65 per cent of the overall holdings. The portfolio value drops from RM1,000,000 to RM863,000. That’s 13.7 per cent drop. Under such a circumstance, we would suggest a rebalancing to be done even though the six month period is not due yet.
Table 4
Based on the figure in Table 4, you would need to sell RM44,100 worth of your bond to buy RM44,100 worth of equity to return to the original asset allocation percentage. By applying the rebalancing strategy, you don’t have to decide on what you should do or shouldn’t do in the current market condition. By adhering to the rebalancing strategy, you will automatically buy low and sell high. When you do that, you will always gain more and optimise your investment return. If you don’t feel like putting a new money into the market, you can at least rebalance your investment portfolio. By doing so, you will end up having more equity to benefit more when equity market recovers later.
Critical assumptions required
However, there are two important assumptions to make the rebalancing strategy work. First, you must be sure of the quality of your current investment assets. In that case, you can be sure that the price drop is due to overall market sentiment and not because of the poor performance of your specific investment asset. Then, the price of your investment asset will rebound when the market recovers. Second, you must make sure that you have the holding power to hold your investment for more than three years. In that case, you are not worry if the market were to fall further. If you don’t have the holding power and you need to use the money urgently, you may have to sell your investment at a bigger loss. To invest successfully, it is never enough to just know and understand about a strategy. I am sure that many people may have read about rebalancing strategy before. But what is more important to succeed is to know how and when to apply the strategy. Now is the time for you to apply the strategy.
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