Strategies for investing in volatile markets

Julian Robertson suggests a practical strategy when introducing money into the market and another for managing existing portfolios.

There’s no doubt that it’s a difficult environment to be investing in risk assets or indeed managing them on behalf of others.

We've become so familiar with the term 'risk-on/risk-off' that we’re almost immune to it, but a quick look at the monthly returns over the past three years reveals the extent of the market’s mood from one period to the next.

So what can investors do to mitigate this volatility and gain enough confidence to forge ahead or perhaps dip a toe in the water? Here are three suggestions which might help.

Maintain a long-term approach

Attempting to time markets or react to their whims on the basis of sentiment is generally a poor strategy for maintaining and growing wealth.

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Multiple surveys and history show that very few market timers have been consistently successful. We believe that it is almost impossible to predict and profit from short-term market moves with any accuracy or consistency.

By way of example, we examined the 100 months to 30 November 2011, and found that if $10,000 had been invested in the S&P/ASX200 Index at the beginning of the period, the closing value would have been $13,195.

However, if the returns on the 10 best months are excluded – the investment was removed immediately before the month, and then invested after – the end value return would be only $7,525.

This equates to the difference between a 32.0 per cent gain and a 25.0 per cent loss, and provides a clear illustration of the potential dangers of being out of the market during its best months, and potential results of poor timing.

Dollar cost averaging

In general, dollar cost averaging is a sound strategy for long-term wealth accumulation, as it ensures that the investor buys more units as the market falls, thereby benefitting from the eventual recovery to a greater degree.

As volatility is likely to persist, this could be an excellent way of building exposure to growth assets in a risk-managed way. An investor does not need to commit the sum of their investable assets at the outset, but can invest gradually, taking advantage of the natural gyrations of the market in a non-emotive way.

Rebalancing

The third option is to rebalance the portfolio at either specific points in time or once percentage tolerances have been breached, or a combination of the two.

Although there is no widely-accepted norm for this process, it acts to maintain the asset allocation in line with the risk profile to help the portfolio deliver according to expectations.

Rebalancing is more about managing risk than about enhancing returns.

For example, we started with a 70-30 growth-income split using our current asset allocation and relevant indices as a proxy for our growth portfolios as at 31 December 2004.

We examined market peak and trough points between 31 December 2004 and 31 May 2012 to compare our mock portfolio's asset allocations to those that the 'set and forget' approach would have generated.

Figures 1 and 2 show the results.

Figures 1 and 2 demonstrate that at the top of the market (30 September 2007), the broad growth-income split was 76-24 per cent, whereas the split at the bottom of the market (31 March 2009) was 61-39 per cent.

Therefore, without rebalancing, the asset allocation is potentially most weighted to risk assets at the peak of the market, while being most underweight risk assets at the trough.

A calendar-based rebalancing policy (for instance, annually at year-end) can mitigate some of this risk, leading to a smoother ride to the overall outcome.

Allocation-based tolerance levels can also act as a trigger to rebalance, but setting these too low would require multiple transactions and is difficult to implement cost-effectively.

Setting the tolerances too high could result in a portfolio that does not match the investor's risk profile and in even bigger distortions at peaks and troughs in the markets.

A tolerance level of between plus and minus 5 and 10 per cent might be appropriate.

This means that a typical growth portfolio with a 70-30 growth-income split would have to rise around 30 per cent (assuming no change in the defensive assets) to breach a 5 per cent tolerance limit, whereas growth assets would have to rise around 22 per cent to breach the 5 per cent tolerance limit of a typical 50-50 growth-income portfolio.

Either way, any rebalancing strategy must be adhered to in a systematic and disciplined fashion, otherwise the temptation to 'market time' might overwhelm the decision to rebalance.

Avoiding market timing, implementing dollar cost averaging and rebalancing will not eradicate entirely the emotional tug markets have on investors.

These can, however, be useful techniques for establishing a mindset and a simple framework for managing the volatility inherent in investment markets.

Using all or a combination of these three strategies – depending on circumstances and costs – can help the achievement of long-term investment goals.

Julian Robertson is a senior research analyst with Morningstar.