Timing markets is not easy. Convention has led to asset mixes that reflect the investor’s risk tolerance or desired level of return, based on historical results. Periodically rebalancing to that fixed strategic asset mix has become routine.

If investment time horizons are long enough that losses on one cycle can be made up by gains over the next one, this approach is fine. But rebalancing to a fixed mix has shortcomings, for example, when all asset classes move together.

Chart 1 shows the risk (standard deviation) of a 60% Canadian equity and 40% Canadian bond portfolio from February 2001 to February 2014. Its risk remained between 5% and 10%, with a notable spike to 25% during the financial crisis.

The dotted line represents the long-term risk average of 7.5%.

To test how maintaining a consistent level of risk would impact the portfolio, we adjusted the asset mix to keep the portfolio risk close to 7.5%. The result? Portfolio risk was lower whenever market risk increased, and vice versa (see Table 1). The portfolio’s return improved, overall risk was reduced, and most importantly, the worst 12-month period was -5% instead of -25%.

To cope with market volatility, target a risk level in your portfolio instead of an asset mix, and manage to it. Know when your risks are greater than your ability to overcome them.


Chart: Holding risk constant


Table: Holding risk constant

Originally published on Advisor.ca

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