Should I pause rebalancing during extreme volatility?

Should You Pause Rebalancing During Extreme Volatility💡 Definition:How much an investment's price or returns bounce around over time—higher volatility means larger swings and higher risk.?

Navigating the choppy waters of financial markets can be challenging, especially during periods of extreme volatility. One common question investors face is whether to pause rebalancing their portfolios during these turbulent times. While the answer depends largely on individual circumstances, pausing rebalancing entirely is generally not recommended for most investors. Let's explore why maintaining a disciplined approach to rebalancing can be beneficial, even when the market gets rocky.

The Role of Rebalancing

Rebalancing is the process of realigning the weightings of a portfolio of assets💡 Definition:Wealth is the accumulation of valuable resources, crucial for financial security and growth. to maintain a desired level of asset allocation💡 Definition:The mix of different investment types in your portfolio, determining both risk and potential returns. This practice is crucial for managing risk and ensuring that your investment strategy aligns with your financial goals. A rebalanced portfolio tends to experience less volatility—16% less, to be precise—than one that isn't regularly rebalanced. During the 2008 financial crisis, portfolios that were rebalanced saw significantly smaller losses compared to those that were left unchecked.

Why Pausing May Be Tempting

During periods of extreme volatility, the market can be unpredictable. Investors may be tempted to pause rebalancing for several reasons:

• Transaction Costs: Volatility often leads to increased transaction costs, which can eat into investment returns.
• Emotional Stress: The psychological strain of seeing assets lose value can lead to hasty decisions.
• Timing Concerns: Fear of selling low and buying high can deter investors from acting.

However, allowing your portfolio to drift too far from its target allocation can increase risk, making you more vulnerable to further market declines.

Framework for Decision-Making

When considering whether to continue rebalancing during volatility, use this three-step framework:

1. Assess Your Risk Capacity

First, evaluate if your financial situation has changed. If your risk capacity has diminished—perhaps due to a job loss or other financial setbacks—it may be wise to adjust your strategic policy rather than halt rebalancing.

2. Confirm Alignment with 💡 Definition:Risk capacity is your financial ability to take on risk without jeopardizing your goals.Risk Tolerance💡 Definition:Your willingness and financial ability to absorb potential losses or uncertainty in exchange for potential rewards.

Ensure your policy allocation still aligns with your risk tolerance. Most strategic policies require regular rebalancing to maintain the intended risk level.

3. Evaluate Market Outlook

Consider your capital market outlook for the next 3-6 months. If your view is more pessimistic than originally assumed, you might opt for tactical risk reduction. If your outlook is stable, continue with your policy allocation.

Strategies for Volatile Times

Instead of pausing rebalancing, consider these alternative strategies:

• Tighter Rebalancing Boundaries: For example, if your target allocation is 50% stocks, adjust your rebalancing trigger from 55% to 53% during volatile periods. This maintains discipline while reducing transaction frequency.
• Overlay Strategies: Using derivatives💡 Definition:Derivatives are financial contracts that derive value from underlying assets, helping manage risk and enhance returns. or other cost-effective instruments can help institutional investors rebalance💡 Definition:The process of realigning your investment portfolio back to your target asset allocation by buying and selling assets. without incurring significant transaction costs, automating the process and removing emotional bias.

Real-World Example

Consider an investor with a $1 million portfolio allocated 60% to stocks and 40% to bonds💡 Definition:A fixed-income investment where you loan money to a government or corporation in exchange for regular interest payments.. If the stock💡 Definition:Stocks are shares in a company, offering potential growth and dividends to investors. market drops by 30%, their stock allocation might fall to 50%, reducing overall risk. Rebalancing back to the 60/40 target during the downturn can position the investor to benefit from a market recovery. In fact, during the 2008 crisis, a rebalanced portfolio lost $200,000 less than an un-rebalanced one under similar conditions.

Common Mistakes to Avoid

• Overreacting to Market Swings: Avoid the trap of becoming overly risk-averse during downturns, which can lead to selling low and buying high.
• Ignoring Policy Allocations: Letting portfolios drift far from their intended allocations can disconnect actual risk from your risk tolerance, as seen during the 2000 bull market💡 Definition:20%+ sustained market rise from recent low. Characterized by optimism, economic growth, and rising prices. Opposite of bear market..

Bottom Line

Maintaining rebalancing discipline during volatility helps keep your portfolio aligned with your financial goals and risk tolerance. Rather than pausing entirely, optimize your approach by adjusting rebalancing frequency, using tighter boundaries, or employing cost-effective strategies like overlays. Remember, disciplined rebalancing can enhance long-term outcomes and reduce portfolio risk, even when the market is in turmoil.