Consider a simple portfolio of stocks and low-risk bonds. For the purposes of this discussion it is reasonable to measure this portfolio’s risk as being the percentage of the portfolio that is in equities. Thus, the risk of a balanced portfolio of stocks and bonds would be its 50% equity exposure.
Let’s look at three long-term approaches to managing a portfolio: buy-and-hold, speculation, and risk management.
The buy-and-hold approach allows the portfolio’s risk to increase as the stock market rises and decrease as the stock market falls. The reason is that the percentage of the portfolio equity will rise as equity values rise (note that the low-risk bonds will change very little in value). The buy-and-hold approach has an unpleasant aspect: in retrospect it will have been most-heavily invested in stocks when the stock market reaches its peak and least-heavily invested in stocks when the stock market hits a low. So although the buy-and-hold approach does not involve trading – it allows markets to generates changes in the portfolio’s risk exposure that result in poor market timing.
The speculation approach includes market-timing approaches. It is any strategy that involves investors jumping into and out of the stock market based on their predictions of whether the market will rise or fall. The speculator might market-time with some of the portfolio or all of the portfolio.
Finally, there is the risk management approach. In this approach the investor only purposely adjusts the equity exposure to match his or her risk preferences. These adjustments could be to match the portfolio risk to the investor’s changing risk tolerances. For example, an investor retiring or losing a good job might quite rationally decide to lower portfolio risk.
But let’s look at a reason to adjust the portfolio when the investor’s risk tolerances have not changed: the need to rebalance. Portfolio rebalancing is the process of bringing portfolio weights back to a target. For example, an investor with a moderate tolerance for risk might opt for a 50% allocation to equities. As markets rise this investor must periodically sell equities to bring the portfolio back to the target allocation of 50%, and must buy additional equities during periods of market declines to maintain the 50% allocation. The principle behind portfolio rebalancing is that it tends to keep the portfolio risk stable – which would seem to be a good approach for investors over periods of time in which their tolerance of risk has not substantially changed.
The key conclusion is this: a buy-and-hold strategy can be viewed as a market-timing strategy in the sense that it allows a portfolio’s risk to change as the market rises and falls. Interestingly, a rebalancing approach is designed to keep risk steady and appears to prevent market-timing.
The next two parts of this series discuss portfolio rebalancing as a market-timing strategy and call attention to some interesting implications of that strategy.