Sophisticated Portfolio Rebalancing
Typical advice for investor portfolios is to choose some asset allocation such as 50% stock and 50% bonds, and rebalance as necessary to maintain this balance. PŮR Investing Inc. offers a different approach that focuses on risk. Their approach actually combines two strategies that are sometimes at odds.
PŮR is critical of typical target date funds that slowly reduce portfolio risk on a fixed schedule as the target retirement date nears. PŮR proposes two strategies:
1. Rebalance individual portfolios to maintain a fixed level of risk rather than a fixed percentage asset allocation.
2. Choose a level of risk over time designed to get the portfolio to a target dollar amount.
The first strategy involves selling out of investments when volatility increases. So, when stock prices start to jump around, shift money to bonds to maintain a fixed risk level, and when stock prices becomes less volatile, shift back.
The second strategy involves choosing a level of risk that maximizes the chances of building the portfolio to a target amount by the investor’s retirement date. PŮR describes this idea delicately by saying that as the portfolio builds close to the target amount, money is shifted to safer investments. This sounds much better than saying that when the portfolio value drops, start taking bigger chances to try to make the money back.
When we think about these strategies in isolation, they tend to sound quite smart. Get out of stocks when they become risky, and buy more stocks when the price is low. But, what do you do if stock prices become more volatile at the same time that they have dropped in value? The two strategies will offset, and minimal action will be taken.
I'm convinced that the second strategy makes sense; investors have little choice but to take some chances to reach a minimum standard of living for retirement. The first idea about maintaining constant risk is intriguing, but I’m still mulling it over. It’s not clear to me whether it will give investors better results than standard asset allocation.
PŮR is critical of typical target date funds that slowly reduce portfolio risk on a fixed schedule as the target retirement date nears. PŮR proposes two strategies:
1. Rebalance individual portfolios to maintain a fixed level of risk rather than a fixed percentage asset allocation.
2. Choose a level of risk over time designed to get the portfolio to a target dollar amount.
The first strategy involves selling out of investments when volatility increases. So, when stock prices start to jump around, shift money to bonds to maintain a fixed risk level, and when stock prices becomes less volatile, shift back.
The second strategy involves choosing a level of risk that maximizes the chances of building the portfolio to a target amount by the investor’s retirement date. PŮR describes this idea delicately by saying that as the portfolio builds close to the target amount, money is shifted to safer investments. This sounds much better than saying that when the portfolio value drops, start taking bigger chances to try to make the money back.
When we think about these strategies in isolation, they tend to sound quite smart. Get out of stocks when they become risky, and buy more stocks when the price is low. But, what do you do if stock prices become more volatile at the same time that they have dropped in value? The two strategies will offset, and minimal action will be taken.
I'm convinced that the second strategy makes sense; investors have little choice but to take some chances to reach a minimum standard of living for retirement. The first idea about maintaining constant risk is intriguing, but I’m still mulling it over. It’s not clear to me whether it will give investors better results than standard asset allocation.
... and I wonder about the cost and complexity of implementing the approach
ReplyDeleteJames,
ReplyDeleteDon't forget that owning collars is another way to significantly reduce portfolio volatility (not market volatility, but the ups in down in the value of your stuff).
And if achieving a certain standard of living is the goal, collars guarantee there will be no large losses. On the other hand, it also limits profits so there will be no huge gains either.
But the possibility of steady gains with no big losses suits me. Others must decide for themselves.
Regards,
Yeah, I don't buy the first one either. If you believe in the concept of a risk premium, you have to believe that market values will decrease when risk increases, so selling when risk increases is a formula for selling low.
ReplyDeleteCanadian Investor: Presumably the cost of the approach would depend on how often you rebalance to hit the risk target.
ReplyDeleteMark: So far I've only examined collars in a couple of instances. Both times the option prices were such that the risk/reward didn't work out well. Now that markets have lower volatility, maybe I would get different results.
Patrick: You may be right about the link between risk premium and share prices, but I haven't looked at this closely. This is one of those questions that I may look into more in the future. for now I'm not ruling out the possibility that risk rebalancing might work.
Michael,
ReplyDeleteI remember the earlier disucssion. puts still cost more than calls, but the difference has decreased.
The biggest drawback to collars is giving up the upside. Some investors simply cannot live with that.
Otherwise, collars can be expected to underperform the averages - in return for extra security.
It's not the ideal solution for everyone. But for those who cannot tolerate 2008 type losses (either emotionally or financially), it's appealing.