2018 turned out to be a volatile year for equity markets, particularly in the calendar fourth quarter when each day seemed to bring wild swings. As an example, in the seven trading days from December 14 to December 24, the Dow Jones Industrial Average fell more than 350 points six times, including the Dow’s worst Christmas Eve on record, dropping 2.9% in half‐a‐day’s trading. When the markets reopened on December 26, the Dow roared back, gaining 1,000 points (or 5%) in the biggest single‐day point gain in its history. Despite reaching its all‐time high on October 3, 2018, the Dow returned ‐5.6% for the year. The S&P 500 Index provides another example—in 2018, the index had a daily gain or loss of more than 1% 64 times (including nine times in December alone), compared to eight times in the entirety of 2017. The S&P 500 Index returned ‐6.2% for the year, after reaching its all‐time high on September 20, 2018.
Following 10 years of strong equity returns, especially for the U.S. large cap companies represented in the Dow and S&P 500 indices, the recent market volatility serves as a reminder that the performance of different asset classes, investment styles and managers can vary greatly from year‐to‐year. Investor preference for investments such as fixed income versus equity securities, international versus domestic stocks, value versus growth stocks, commodities versus real estate, etc., will fluctuate, and while such preferences are often cyclical, they can’t be reliably predicted. Because of this, trying to maximize investment returns through “market timing,” that is, having the foresight to sell an investment at its peak
and buy at its trough, is nearly impossible. Instead, the prudent course is twofold: 1) establish a diverse portfolio with asset class allocation targets that account for an investor’s own risk tolerance; and 2) periodically rebalance the portfolio in order to maintain allocations in line with those targets.
Portfolio diversification has the effect of diluting the risk of overexposure to any single manager or asset class—or to put it more plainly, it prevents an investor from “putting all of their eggs in one basket.” A well‐diversified portfolio will invest in a variety of asset classes and investment styles that are not strongly correlated to each other, with some segments performing well when others are out of favor. This can have the effect of reducing overall volatility.
To demonstrate the benefits of diversification, consider three hypothetical investment scenarios: a $1 investment in Manager A, a $1 investment in Manager B, and a $1 investment split evenly between Managers A and B. For simplicity’s sake, let’s say that each manager’s performance is the exact inverse of each other, such that when Manager A is up 2% for a month, Manager B is down 2%, and so forth (equating to a correlation of ‐1). In such a scenario, each manager will have the same volatility, as measured through the standard deviation of returns. The chart below shows the hypothetical growth of a dollar over the course of 10 years for Manager A, for Manager B, and for a “buy and hold” portfolio
split 50/50 between the two managers at the beginning of the investment period (note that fees, transaction costs and tax impacts are assumed to be zero).
Note that in the hypothetical scenario we’ve constructed above, Manager A and Manager B both have an identical result over the time period, returning $0.86 on the dollar invested, despite taking wildly different paths along the way. A “buy and hold” portfolio split evenly between the two managers at the outset and never rebalanced will also return $0.86 after 10 years; however, the 50/50 portfolio is much less volatile over the time period. Measured through standard deviation of monthly returns, in this example the 50/50 “diversified” portfolio is approximately 69% less volatile than Managers A and B.
Despite these benefits, diversification alone cannot fully address the problem of market volatility—for example, a portfolio with an initial asset allocation target of 70% to equities and 30% to bonds may grow to have a much higher allocation to equities during a bull market run, resulting in an asset allocation outof line with an investor’s risk objectives. But, couple portfolio diversification with rebalancing (i.e., periodically adjusting portfolio asset allocations so they remain in line with their established targets), and the results can seem almost magical. Not only can rebalancing further reduce portfolio volatility, but it can actually increase returns over time.
To demonstrate the potential benefits of rebalancing, let’s revisit our scenario with Managers A and B, but in addition to the 50/50 “buy and hold” portfolio, let’s also compare the performance of a 50/50 portfolio that was rebalanced every quarter (again, fees, transaction costs and tax impacts are assumed to be zero).
In the hypothetical scenario outlined above, rebalancing the portfolio quarterly leaves you with $1.08 at the end of 10 years (an 8% return) versus $0.86 with no rebalancing (a ‐14% return). Again, both the “buy and hold” and the quarterly rebalanced portfolios utilize the same two managers, and both managers generate the exact same return over 10 years—yet the simple act of rebalancing the portfolio quarterly “magically” generates a positive return. How is this possible? While rebalancing can often feel counterintuitive because the process inherently involves taking money away from investments that have grown and putting it towards investments that have underperformed, in fact, viewed another way, regular rebalancing has the effect of automatically “harvesting” portfolio gains during periods of
outperformance and reinvesting them in undervalued segments of the portfolio that have room to grow. Additionally, as is visibly apparent from the graph, rebalancing has the effect of further “smoothing out” performance and dramatically reducing overall portfolio volatility—in this example, the rebalanced portfolio is 89% less volatile than the “buy and hold” portfolio as measured by standard deviation.
Finally, behavioral biases can have a large (and often negative) impact on portfolio performance— psychologically, it’s hard to sell winners and buy losers. Having the discipline to regularly rebalance helps to remove the emotion from investment management decisions and can result in better long‐term performance with less volatility. It’s a discipline we strive to adhere to at Mangham. They say there’s no such thing as a free lunch, but when it comes to investing, rebalancing may be the closest thing.
The Mangham Associates Team