fluctuations. For example, the year 2008 was not an “outlier,” nor was it even the worst year on record. Rather it was tied for the second worst year. It was a one-in-forty year event, not a one-in-a-thousand year event. The frightened investor who decided to get out of the market in March of 2009 locked in his or her losses for good. The chief problem with small investors is they buy when the market has gone up and believe it will rise further, and they sell when the market has fallen and believe it will fall more. One of the principal functions of the right financial advisor is to make sure the investor understands the volatility of his or her specific portfolio and is willing to stick with it for the long run. As Mark Hebner explains, a third implication of the fact that markets fluctuate is the need to rebalance. Suppose an investor is comfortable with a 60-40 mix of stocks versus bonds. If the market rises substantially, the portfolio’s equity exposure will greatly exceed sixty percent. The rebalancing process sells off the excess, bringing the portfolio back to a 60-40 mix. If the market falls, then the portfolio will have less invested in stocks than the target 60 percent. The rebalancing process then buys. This process of rebalancing — which sells when the market is up and buys when the market is down — is sometimes referred to as “volatility capture” and leads to what Fernholz and Shay (1979) refer to as “excess growth.”4 The rebalanced portfolio will grow faster than the average growth of its individual constituents. It may even grow faster than any one of its constituents due to the rebalancing process. Thus, if handled knowledgeably, market volatility can be the investor’s friend.
Published on Jun 1, 2015
This book reveals the potential land mines and pitfalls of active investing and educates readers on the benefits of passive investing with i...