Managing Risk and Reinvesting Profits in Volatile Markets

Who could have anticipated how markets behaved in the last year? It’s a question that comes up time and time again in the world of investing. Today is no different. Who would have predicted a pandemic would cause one of the sharpest equity market declines in recorded history? Who would then have been brave enough to have forecast this would be followed by one of the fastest recoveries? Markets reached new highs while Covid-19 was in the midst of causing immeasurable economic damage across the world. Furthermore, who would have anticipated that as the world finally charted its way out of the pandemic the markets would look less certain than they have throughout the majority of the crisis?

Predicting any one of these events is hard enough, but predicting them all in a row with enough confidence to make investment gains is almost impossible. Getting a prediction wrong could lead to a far worse outcome than no action at all. There is no reason to spend time and energy trying to form predictions that may be wrong when there are systematic, evidence-based ways you can ensure your portfolio is prepared for any eventuality.

Recently, many of our clients have been questioning why we are choosing to sell our international equity funds to buy UK equity and global property funds. In recent years, international equity funds have had their returns bolstered by the strong performance of large US technology companies. Moreover, property and UK equity have both posted lacklustre returns in 2020.

However, rebalancing is an important part of our systematic approach known as rebalancing. Rebalancing often seems misguided initially. However, it is a very sensible step to take in order to manage the risk levels of a portfolio and ensure it has the best chance of meeting the objectives of a financial plan. Recent market activity has shown exactly why rebalancing is an important part of any serious long-term investing strategy.

How does rebalancing help my portfolio?

Rebalancing is where we sell assets that are overperforming and buy assets that are not doing so well. The purpose of this is to ensure that the proportions of different asset types in a portfolio remains the same. This maintains the level of risk adopted by the strategy. For instance, consider a portfolio which is constructed to be 60% equities and 40% fixed income. If the returns on the equity investments are higher than the fixed income, the ratio of one to the other will change. Perhaps the equities grow so much they are now 70% of the total portfolio leaving bonds as only 30%. This would involve a higher degree of risk moving forwards. Rebalancing would correct this by selling equities and using the profits to buy fixed income until the ratio is once again 60:40.

Infographic showing the rebalancing process

This process may seem counter-intuitive to those who want to maximise their returns. Surely, selling assets because they are doing well is counterproductive? The answer to this mindset is simple; just because a certain asset class has been performing well in recent times, there is no guarantee that it will continue to do so in the future. Not rebalancing means the composition, and therefore the risk level, of a portfolio will change over time from what was initially agreed upon. The structure of the investments will go from being built for every eventuality to one which is built to benefit in the market’s current conditions, which could change any time.

Emotionally, it can be tough to sell assets that are doing well and buying ones that aren’t. This is part of the value of having a financial adviser, who will do it for you. We have a well-established strategy that we have complete confidence in. This allows us to be rational and dispassionate when making decisions for our clients that would otherwise be very challenging.

In summary, two key benefits of rebalancing are:

  1. To maintain an appropriate level of investment risk within the portfolio; and
  2. To provide an unemotional and rational approach to reinvesting profits in undervalued assets that stand to benefit over the next market cycle.

Rebalancing and recent market volatility

A real-world example of the need to follow an emotionless strategy is the recent technology boom. International stocks have performed well in recent years, largely thanks to technology companies such as Apple, Google and Amazon. Selling stakes in these companies and choosing to buy weaker performing and undervalued assets such as UK equities and global property is a hard decision, especially when it seems like technology is on an unstoppable rise. Yet for a long-term strategy this is perfectly sensible.

This approach has been vindicated in the last three and six months. Undervalued sectors in UK equity1 and global property2 have outperformed international equities3. This has been beneficial to clients invested in our core portfolios, who throughout 2020 have rebalanced to these undervalued sectors; they have essentially sold overvalued companies at high prices and bought UK and property cheaply. A disciplined rebalancing strategy involves redeploying some profits from assets which are performing better at the time. This manages risk without having to forecast or predict anything.

There is of course no guarantee that these trends will continue. Some may claim this is a sign that technology bubbles are finally ready to burst, and a new market period is approaching. Others will argue this is simply a temporary blip. We prefer not to have an opinion either way. Instead, we make sure our portfolios are managed to take advantage of markets cycles instead of being hurt by them.

1Dimensional – UK Core Equity Fund in GBP

2iShares – Global Property Securities Equity Index (UK)

3Dimensional – International Core Equity Fund in GBP

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