Asset Allocation: A Disciplined Approach in Volatile Markets

Since the Great Recession lows in 2009, U.S. equity markets have seen a nearly unprecedented run, rivaling the longest bull market in the 1990s.

As part of that run, there has also been an extended period of low volatility, enduring only five domestic equity corrections of greater than 10%. However, after almost a decade of consistent and sustained equity market growth, sharp volatility has returned, driven by trade pressures, policy changes and geopolitical concerns.

During the recessionary lows of 2009, some market experts came to believe that Modern Portfolio Theory and general buy-and-hold strategies were dead; and the only way to maintain investment performance was to strategically time trades. In periods of volatility, investor interest in market timing tends to increase as the prospect of making fast money (or cutting losses) gains appeal. However, experience and academia have shown that the ability to consistently and accurately time stock market movements is extremely difficult, if not impossible. Instead, history has demonstrated that adhering to a steady, goal-oriented asset allocation strategy will be more beneficial to investors in the long term.

Asset allocation is the process of dividing an investment portfolio among different asset categories after modeling the risk/reward of each of the categories in combination. This process seeks to provide the best possible risk-adjusted returns given an individual’s time horizon, financial goals and overall risk tolerance. Put simply, asset allocation looks to invest in various asset categories and benefit from the tendency that some will zig while conceding that others may zag. A proper asset allocation allows a portfolio to withstand multiple market cycles for varying asset classes as the diversification of the portfolio assists in smoothing out overall returns during periods of volatility in a specific asset category.

Studies have shown that asset allocation can account for over 90% of the variability of portfolio returns. Meaning that portfolio returns are influenced, for better or for worse, more so by allocation decisions than by market timing or individual stock selection within each asset category.

The benefits of asset allocation only accrue when adhered to over time. To illustrate this point, from 1961 to 2015, the S&P 500 had an average annual return of 9.87%. Hypothetically, if you broke from your strategy and somehow missed the 25 best trading days for the S&P 500 during that same time period, such break would have resulted in an average annual return of only 5.74%. These best performing days often occur after some of the worst one-day selloffs in the market or prolonged corrections/recessions over a period of time. While the S&P 500 only represents one asset class, the example demonstrates the importance of being disciplined during downturns.    

It is important to understand that both volatility and corrections are normal and healthy for markets. These cycles are necessary to prevent stock prices from rising to inflated levels which in turn can lead to a more severe bear market. So, in times of heightened volatility what should a disciplined investor do?

Review Your Plan

  • Review both your short- and long-term portfolio goals. Ensure you have sufficient liquidity for any cash flow needs. Position your portfolio so you are not forced to liquidate assets in a period of market weakness.
  • Review your portfolio time horizon. Has your timeline shifted due to certain life events? Always be cognizant of whether your long-term objectives are in line with your overall portfolio and risk allocation.
  • Review your strategic asset allocation. Is it optimized based on your goals and time horizon? Rebalance your portfolio if necessary.

Stick To Your Plan

  • Remove emotion from any decision making and focus on fundamentals. The worst decision an investor can make is overreacting to a short-term correction and missing the corresponding rebound. Focus on what you can control and stick to your well-developed plan.
  • Use dollar-cost averaging to allocate investable cash within your asset allocation. This will not only help to potentially bolster returns during market corrections, but also help avoid the potential for inopportune market timing.
  • When in doubt, do nothing and take a hands-off approach. If your portfolio is diversified and meets your time horizon, financial goals and risk tolerance, simply sit back and be confident in the well-formulated plan you have established. Do not stress yourself over short-term volatility or daily headline news that is not impactful to your longer-term forecast.

Bull and bear markets are part of investing. History has shown however that successful investors do not overreact to market runs and adjustments. Instead, these investors develop thoughtful, cohesive plans that fit their needs and stay the course over the long run.