Do you take advantage of "volatility" in your investing strategy?

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Ron Scott
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Do you take advantage of "volatility" in your investing strategy?

Post by Ron Scott » Mon Oct 22, 2018 11:25 pm

I once thought rebalancing was an approach that gave one a leg up in the use of market volatility. Then I was educated that holding without rebalancing actually produced better long-term gains. I do not rebalance now, or at least it is not in my plans to do so.

I do consider tax rates to be volatile and I plan to Roth convert fairly aggressively for the next few years as I think we're be headed into significantly higher brackets in the future.

Do you attempt to take advantage of volatility for gain?
Retirement is a game best played by those prepared for more volatility in the future than has been seen in the past. The solution is not to predict investment losses but to prepare for them.

MinhN
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Re: Do you take advantage of "volatility" in your investing strategy?

Post by MinhN » Mon Oct 22, 2018 11:36 pm

I only take advantage of volatility to tax loss harvest in my taxable account.

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whodidntante
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Re: Do you take advantage of "volatility" in your investing strategy?

Post by whodidntante » Mon Oct 22, 2018 11:42 pm

The market is still pretty high, unless you've been overweighting China and a few other markets that have been beat down. The market owes us nothing.

The main thing I do is tax loss harvest when I have significant losses. I've never done a Roth conversion because my tax rate has been high for several years now. If I have a low income year, I'll take advantage.

stlutz
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Re: Do you take advantage of "volatility" in your investing strategy?

Post by stlutz » Mon Oct 22, 2018 11:47 pm

I once thought rebalancing was an approach that gave one a leg up in the use of market volatility. Then I was educated that holding without rebalancing actually produced better long-term gains. I do not rebalance now, or at least it is not in my plans to do so.
Suppose you start out with 50% equities. Over time prices go up and you have 60% equities. The question is not whether it's better to start with 50% equities and never rebalance. The proper comparison is to a portfolio of 55% equities that you rebalance periodically. Which do you think does better?

MotoTrojan
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Re: Do you take advantage of "volatility" in your investing strategy?

Post by MotoTrojan » Tue Oct 23, 2018 1:38 am

stlutz wrote:
Mon Oct 22, 2018 11:47 pm
I once thought rebalancing was an approach that gave one a leg up in the use of market volatility. Then I was educated that holding without rebalancing actually produced better long-term gains. I do not rebalance now, or at least it is not in my plans to do so.
Suppose you start out with 50% equities. Over time prices go up and you have 60% equities. The question is not whether it's better to start with 50% equities and never rebalance. The proper comparison is to a portfolio of 55% equities that you rebalance periodically. Which do you think does better?
This.

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JoMoney
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Re: Do you take advantage of "volatility" in your investing strategy?

Post by JoMoney » Tue Oct 23, 2018 2:34 am

stlutz wrote:
Mon Oct 22, 2018 11:47 pm
I once thought rebalancing was an approach that gave one a leg up in the use of market volatility. Then I was educated that holding without rebalancing actually produced better long-term gains. I do not rebalance now, or at least it is not in my plans to do so.
Suppose you start out with 50% equities. Over time prices go up and you have 60% equities. The question is not whether it's better to start with 50% equities and never rebalance. The proper comparison is to a portfolio of 55% equities that you rebalance periodically. Which do you think does better?
The answer is "it depends"...
but it really shouldn't matter, I expect the bond portion to be there to mitigate the risk, not to increase returns. I wouldn't expect 'rebalancing' or any other trading scheme to add to returns either.
That said, I'm also not a fan of rebalancing... or at least only doing it in one direction from stocks to bonds.
"To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks." - Benjamin Graham

Ron Scott
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Re: Do you take advantage of "volatility" in your investing strategy?

Post by Ron Scott » Tue Oct 23, 2018 4:54 am

stlutz wrote:
Mon Oct 22, 2018 11:47 pm
I once thought rebalancing was an approach that gave one a leg up in the use of market volatility. Then I was educated that holding without rebalancing actually produced better long-term gains. I do not rebalance now, or at least it is not in my plans to do so.
Suppose you start out with 50% equities. Over time prices go up and you have 60% equities. The question is not whether it's better to start with 50% equities and never rebalance. The proper comparison is to a portfolio of 55% equities that you rebalance periodically. Which do you think does better?
If you started with 50% equities based on a dollar loss estimate in assessing your risk tolerance, 55% could not be a proper comparison since it didn’t meet your needs in the first place. The proper comparison for those who see risk tolerance in estimated dollar loss (vs. percentage) is between rebalancing and not rebalancing.

Which do you think does better?
Retirement is a game best played by those prepared for more volatility in the future than has been seen in the past. The solution is not to predict investment losses but to prepare for them.

rkhusky
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Re: Do you take advantage of "volatility" in your investing strategy?

Post by rkhusky » Tue Oct 23, 2018 6:21 am

Ron Scott wrote:
Mon Oct 22, 2018 11:25 pm
I once thought rebalancing was an approach that gave one a leg up in the use of market volatility. Then I was educated that holding without rebalancing actually produced better long-term gains. I do not rebalance now, or at least it is not in my plans to do so.
If all you are looking for is better long-term gains, then being 100% stocks has produced the best long-term gains in the past.

Rebalancing is usually advised to control risk. Not rebalancing has generally produced a higher stock allocation over time, which has increased risk and expected return in the past.

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nisiprius
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Re: Do you take advantage of "volatility" in your investing strategy?

Post by nisiprius » Tue Oct 23, 2018 6:29 am

I do not. Not intentionally. Not as far as I know.

I rebalance for the purpose of saying comfortably close to my target asset allocation. It turns out that if that is the only reason for rebalancing, and if you are using simple, broad index funds, you don't actually need to do that very often, not even annually!

Generally speaking, there have always been people who believe they can beat the market by shrewd reading of market psychology and good timing of purchases. If you think you can do that, then, of course, volatility is what makes it possible. Furthermore, some people seem to like criticizing the risk aversion typical of many investors, and enjoy saying how much they love volatility.

My belief is that various rebalancing rules and systems simply add a bit of random noise to the system, that sometimes helps and sometimes hurts, and that explorations of "optimal" rebalancing strategies are unconvincing (there's never enough data, the actual results depend on how the actual strategy happens to line up with the actual detailed stock market movements over the study period).

I would say that one of the most problematical and frequently debated questions in this forum is one that can be asked several ways:

a) Can rebalancing actually manufacture extra return out of pure volatility?

b) Is rebalancing a kind of gentle market timing that works, an automatic way to "buy low, sell high?"

c) Is there a "rebalancing bonus?"

The big problem is getting past self-deceptive, inaccurate mental models of stock market behavior. For example, it is tempting to fantasize that any reasonable "rebalancing rule," even if it didn't call the exact bottom in 2008-2009, would surely have resulted in worthwhile gain due to "buying low." It's really necessary to look at how the rule "firing" would generate pairs of purchases and sales, for which profits and losses can be calculated.

An essential point is that the results depend on whether the actual behavior of the assets during the time periods between a rebalancing purchase and a matched sale showed "momentum" or "mean reversion." It is widely believed that both effects are seen, typically momentum over time periods of 6 months or less, mean reversion over time periods of several years or more.

The second essential point is that in the presence of momentum, rebalancing is harmful, relative to holding. Going up, it results in repeatedly foregoing gains because of premature sales. Going down, it repeatedly fails to cut losses. Rebalancing is only beneficial if the timing of rebalancing resonates with mean reversion. This does indeed suggest rebalancing intervals of more than a year.

A third point is one I personally observed during 2008-2009. Compared to buying and holding, rebalancing slightly amplifies the depths of a drawdown; that is, increases risk. I held the Vanguard Balanced Index Fund, which is 60% Total Stock, 40% Total Bond, rebalanced "continuously." I noticed that if (say) Total Stock fell 10% and Total Bond was unchanged, Balanced Index--which might naïvely have been expect to fall 10%-of-60% = 6%, fell noticeably more than that. This is because during a decline, rebalancing continuously throws good money after bad, raiding the stable bonds to keep buying stocks which keep declining. During the rise, the opposite occurs; over and over again you are taking profits on rising stocks. In theory, in fantasy, in a sufficiently extreme cases, if an asset class "goes to zero" and you are extremely literal minded about constantly selling everything else in order to keep buying that asset class, a sufficiently bad asset class could suck your entire portfolio into it. Of course if it eventually does come up, everything is OK, but...

A "mystery" is whether rebalancing can help in the situation where there is a true random walk, e.g. over a time period when there is neither momentum nor mean reversion. (For stocks, that has true for periods of about one year--the S&P 500 for one year has shown near-zero correlation with the previous year). I'm putting "mystery" in scare quotes because I believe the answer is no--William J. Bernstein has said so, and he's one of the people who coined and popularized the phrase "rebalancing bonus." I have great confidence in Bernstein, but I will tell you that some forum members have been extremely strong and powerful in their assertions that there is a bonus even with a random walk. It is very tricky (like discussions of the Monty Hall problem) because it is surprisingly difficult to construct a legitimate simulation that doesn't accidentally sneak in mean reversion behavior.
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longinvest
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Re: Do you take advantage of "volatility" in your investing strategy?

Post by longinvest » Tue Oct 23, 2018 7:29 am

stlutz wrote:
Mon Oct 22, 2018 11:47 pm
I once thought rebalancing was an approach that gave one a leg up in the use of market volatility. Then I was educated that holding without rebalancing actually produced better long-term gains. I do not rebalance now, or at least it is not in my plans to do so.
Suppose you start out with 50% equities. Over time prices go up and you have 60% equities. The question is not whether it's better to start with 50% equities and never rebalance. The proper comparison is to a portfolio of 55% equities that you rebalance periodically. Which do you think does better?
Good question!

Let's check this using a US stocks (VTI) / US bonds (BND) portfolio. I've selected, below, the Oct 2013 - Sep 2018 time period in which a 50/50 non-rebalanced allocation drifted to 60/40. Unsurprisingly, I find that a rebalanced 55/45 portfolio had similar total growth, returns, and average volatility over the same time period.

NON-REBALANCED 50/50 PORTFOLIO

Source: Portfolio Visualizer

Portfolio:
Image

Allocation drift:
Image

Returns:
Image

REBALANCED 55/45 PORTFOLIO

Source: Portfolio Visualizer

Portfolio:
Image

Returns:
Image

SO, WHY REBALANCE?

That's the key question, right? Both portfolios had almost identical average returns and volatility. Why rebalance?

The answer is: to manage risk. What risk? The risk of ending up with too many of one's eggs in one basket. The risk that stocks crash after the allocation has drifted, causing bigger portfolio losses.

A 50/50 non-rebalanced portfolio started in March 2009 would have drifted, by now, to a 76/24 portfolio. It would have had similar returns and volatility to a rebalanced 63/37 portfolio. If stocks were to drop 50%, the 76/24 portfolio would lose 38% of its value whereas the 63/37 portfolio would only lose 31.5% of its value and end up 10% ahead of the non-rebalanced portfolio after the crash, while having experienced similar average returns and volatility before the crash.

Note that the same analysis in a bear market yields similar results. Refraining from selling bonds to buy stocks, during a bear market, decreases the average stock allocation of the portfolio. Had the portfolio been allocated with the effective average stock allocation from the start (e.g. more bonds), and then been rebalanced, it would have experienced similar average returns and volatility. But, in the subsequent recovery, the rebalanced portfolio would end up ahead.

I think that it's a mistake to hope for a "rebalancing bonus". In the long run, a leveraged all-stocks portfolio (something like 140% stocks, if I remember correctly, according to the Kelly criterion) is most likely (not guaranteed!) to beat a mixed portfolio of stocks and bonds. Adding bonds to a portfolio is a risk management decision, not a return maximization strategy, and rebalancing goes along with that decision.
Bogleheads investment philosophy | Lifelong Portfolio: 25% each of (domestic/international)stocks/(nominal/inflation-indexed)bonds | VCN/VXC/VLB/ZRR

ThrustVectoring
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Re: Do you take advantage of "volatility" in your investing strategy?

Post by ThrustVectoring » Tue Oct 23, 2018 2:26 pm

Ron Scott wrote:
Mon Oct 22, 2018 11:25 pm
I once thought rebalancing was an approach that gave one a leg up in the use of market volatility. Then I was educated that holding without rebalancing actually produced better long-term gains. I do not rebalance now, or at least it is not in my plans to do so.

I do consider tax rates to be volatile and I plan to Roth convert fairly aggressively for the next few years as I think we're be headed into significantly higher brackets in the future.

Do you attempt to take advantage of volatility for gain?
Rebalancing does give a leg up from market volatility. It's just that the size of this effect is smaller than the excess returns of stocks over bonds. The Kelly Criterion describes the balancing point between these two effects, and depending on your assumptions about expected volatility and returns, it spits out something like 140% of your portfolio balance "should" be in stocks.
Current portfolio: 60% VTI / 40% VXUS

rakamaka
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Re: Do you take advantage of "volatility" in your investing strategy?

Post by rakamaka » Wed Oct 24, 2018 8:29 am

longinvest wrote:
Tue Oct 23, 2018 7:29 am

SO, WHY REBALANCE?

That's the key question, right? Both portfolios had almost identical average returns and volatility. Why rebalance?

The answer is: to manage risk. What risk? The risk of ending up with too many of one's eggs in one basket. The risk that stocks crash after the allocation has drifted, causing bigger portfolio losses.
I think that it's a mistake to hope for a "rebalancing bonus". In the long run, a leveraged all-stocks portfolio (something like 140% stocks, if I remember correctly, according to the Kelly criterion) is most likely (not guaranteed!) to beat a mixed portfolio of stocks and bonds. Adding bonds to a portfolio is a risk management decision, not a return maximization strategy, and rebalancing goes along with that decision.
Thank you longinvest. You are the only on on this forum to understand real meaning of rebalance stocks and bonds for taming volatility/risk. Rest other are too busy to find magical mathematical ratios 60:40 40:60 without even understand why it is necessary to rebalance periodically.

aristotelian
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Re: Do you take advantage of "volatility" in your investing strategy?

Post by aristotelian » Wed Oct 24, 2018 8:49 am

longinvest wrote:
Tue Oct 23, 2018 7:29 am

I think that it's a mistake to hope for a "rebalancing bonus". In the long run, a leveraged all-stocks portfolio (something like 140% stocks, if I remember correctly, according to the Kelly criterion) is most likely (not guaranteed!) to beat a mixed portfolio of stocks and bonds. Adding bonds to a portfolio is a risk management decision, not a return maximization strategy, and rebalancing goes along with that decision.
Yes, that is the case for rebalancing to bonds when stocks are up. What would you say about rebalancing to stocks when they are down? That does seem to be about maximizing return.

longinvest
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Re: Do you take advantage of "volatility" in your investing strategy?

Post by longinvest » Wed Oct 24, 2018 10:37 am

aristotelian wrote:
Wed Oct 24, 2018 8:49 am
longinvest wrote:
Tue Oct 23, 2018 7:29 am

I think that it's a mistake to hope for a "rebalancing bonus". In the long run, a leveraged all-stocks portfolio (something like 140% stocks, if I remember correctly, according to the Kelly criterion) is most likely (not guaranteed!) to beat a mixed portfolio of stocks and bonds. Adding bonds to a portfolio is a risk management decision, not a return maximization strategy, and rebalancing goes along with that decision.
Yes, that is the case for rebalancing to bonds when stocks are up. What would you say about rebalancing to stocks when they are down? That does seem to be about maximizing return.
The case for rebalancing when stocks are down is all about choosing the appropriate asset allocation (AA) in the first place. Let's look at the allocation drift of a 50/50 US Stocks / US Bonds (VTI/BND) portfolio where the investor decided not to rebalance bonds into stocks during the 2008-2009 financial crisis:

Source: Portfolio Visualizer
Period: Jan 2008 - Feb 2009
Image

The AA started at 50/50 and finished at 37/63 stocks/bonds. Over the period, the average AA was 43.5/56.5 stocks/bonds. ADDED: I forgot to explain how I got this. I simply took the initial and final allocation to stocks divided by two: ((50 + 37) / 2) = 43.5.

I am saying that the investor should have chosen an AA with a higher allocation to bonds from the start, like 43.5/56.5 stocks bonds (Portfolio Visualizer), and then rebalanced his portfolio.

Here are the outcomes for the 50/50 non-rebalanced and 43.5/56.5 rebalanced portfolios:

Code: Select all

Jan 2008 - Feb 2009 (VTI/BND)
Portfolio         Initial Final   CAGR   Stdev	
50/50 (drift)     $10,000 $7,794 -19.24% 11.77%
43.5/56.5 (rebal) $10,000 $7,763 -19.51% 11.59%
Both portfolios experienced an almost identical loss with almost identical average volatility. In other words, there was no advantage to holding a 50/50 non-rebalanced portfolio over a 43.5/56.5 rebalanced portfolio over that period.

But, the market reversed its direction. If we extend the time period from Jan 2008 to Dec 2010, we can see the clear difference between the inconsistently allocated portfolio that started at 50/50 and then let the market decide of its allocation, and the consistently allocated and rebalanced 43.5/56.5 portfolio:

Code: Select all

Jan 2008 - Dec 2010 (VTI/BND)
Portfolio         Initial Final  CAGR   Stdev	
50/50 (drift)     $10,000 $10,650 2.12% 10.41%
43.5/56.5 (rebal) $10,000 $10,943 3.05% 10.78%
Almost two years after the bottom of the bear market, the annualized return (CAGR) of the 50/50 non-rebalanced portfolio was lagging behind by almost 1%, without any benefit (almost identical volatility).

My point is this: There's no reason to add bonds to a portfolio if the goal isn't to manage risk. Rebalancing is part of this. Avoiding rebalancing (or not rebalancing into stocks) to reduce losses is illogical; the same loss protection can be achieved by simply choosing a higher allocation to bonds in the first place. This will, of course, reduce the potential upside of the portfolio, but it will do so consistently. A non-rebalanced portfolio reduces potential gains at the worst of times, at the bottom of a bear market, and it increases potential losses at the worst of times, at the top of a bubble; it's an illogical approach to risk management.
Bogleheads investment philosophy | Lifelong Portfolio: 25% each of (domestic/international)stocks/(nominal/inflation-indexed)bonds | VCN/VXC/VLB/ZRR

stlutz
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Re: Do you take advantage of "volatility" in your investing strategy?

Post by stlutz » Wed Oct 24, 2018 9:18 pm

Suppose you start out with 50% equities. Over time prices go up and you have 60% equities. The question is not whether it's better to start with 50% equities and never rebalance. The proper comparison is to a portfolio of 55% equities that you rebalance periodically. Which do you think does better?
So let me come back to my own question. If you pick a period that has both a bull and a bear market, the rebalanced portfolio will do better because you are higher in stocks at the market bottom and lower in stocks at the market top.

But to consider more broadly, I agree with longinvest that managing risk is a big part of it. But I'd also say that it's about managing return as well.

A goal one should have in constructing a portfolio is to ensure that you get the returns that you should get for the amount of risk you are taking (whatever that return ends up being). One way that is done is by diversifying. Over the next 10 years, I'd figure that Cisco System stock should perform about the same as the overall market. But that doesn't mean I should concentrate all of my stock investments in CSCO. If I did that, my returns would be almost entirely driven by things specific to that one company, which makes the result more of a lottery ticket than anything. By buying thousands of stocks, I know I'll get what I should get--not more, not less.

Rebalancing accomplishes much the same thing. I don't know when the market will perform well or poorly. So why would I concentrate my risks into certain periods of time? By diversifying across time, I again increase my chances that I'll get what return I should get from investing in the stock market.

UpperNwGuy
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Re: Do you take advantage of "volatility" in your investing strategy?

Post by UpperNwGuy » Wed Oct 24, 2018 10:06 pm

I have a buy-and-hold investment strategy. I ignore volatility.

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