Profiting From Recent Market Volatility

I wish I could say I felt nothing more about this market correction than indifference, but I’d be lying.

Watching all those red downward arrows and negative numbers scrolling across the screen evokes unpleasant emotions, like anxiety. And though the emotional side of me makes me want to react, the logical side kicks in to make sure I don’t. That’s because the logical side is about acting, not reacting. It’s also about seeing opportunity stemming from those who are letting their emotions get the best of them.

A Little Background

The graph below tracks the total returns (including dividend reinvestments) of the three broadest asset classes—U.S. stocks, international stocks and U.S. investment-grade bonds. I graphed the mutual fund versions, as the ETFs didn’t exist at the turn of the century. Today they would be the Vanguard Total Stock Market ETF (VTI | A-100), the Vanguard Total International Stock ETF (VXUS | A-99) and the Vanguard Total Bond Market ETF (BND | A-94).

Most people are surprised to see that bonds have soundly beaten stocks so far this century. But the real point of the chart is the volatility of stocks—especially international stocks—versus the boringness of bonds. That stark difference creates opportunity.

Over the period through June 30 of this year, the simple average of the three funds turned in a rather dismal 4.49 percent annual return. But a portfolio of the same funds, rebalanced every six months in the middle and end of the year, returned an extra 0.48 percent annually, or 4.97 percent.

The rebalanced average was more than the funds themselves. If this doesn’t seem like much, consider that $1 million in the rebalanced portfolio earned an extra $144,690 over the buy-and-hold portfolio.

Implications For Investors Now

No one knows whether the recent so-called plunge is a blip in the bull market or the beginning of the third half-off stock sale of the century. But I know something almost as important. If stocks really do plunge, investors will find they are not as risk tolerant as they thought they were when the bull had its sixth birthday. Many will sell stocks, and that’s why Morningstar data and other studies show investors typically underperform the funds themselves by about 1.5 percent annually.

This recent volatility creates fear and pain as well as an opportunity for those willing to embrace the pain. Or, in the words of Warren Buffett, “Be greedy when others are fearful.” Quite frankly, I often recommend conservative portfolios, because it makes it less hard to buy stocks after a plunge. Notice I didn’t say “easy,” and I never use a risk profile survey to set an allocation.

Finally, I grant that the first part of this century has been outstanding for bonds and not so good for stocks. It’s highly unlikely that bonds will do as well in the next 15.5 years, and stocks may indeed do much better going forward.

But the point is that rebalancing during volatile markets is likely to boost returns over the long run. Though nothing in life is guaranteed, as long as human nature continues and capitalism survives, it’s a pretty good bet.

Allan Roth is founder of Wealth Logic LLC, an hourly based financial planning firm. He is required by law to note that his columns are not meant as specific investment advice. Roth also writes for AARP publications. At the time of this writing, he owned share classes of VTI, VXUS and BND.