Buying into a bear market is a tricky thing, and the volatility we’ve experienced this year is enough to test anyone’s nerves.
We don’t want to be market timers, but we also don’t want to miss an opportunity to buy “on a dip”. We know we shouldn’t try to time the market, but we also know we should have a strategy for rebalancing our portfolios. Today, I’ll share a strategy I’ve developed to address the market volatility, along with some thoughts on the following questions:
- Should we have a strategy for buying into a bear market?
- When should we rebalance, and should it change in the midst of volatility?
- What should we be doing to manage our investments during a time of market uncertainty?
In short, how should we manage our portfolios given the volatility in the current market? I’ve developed a strategy I’m calling “The 5% Rebalancing Strategy” which I’ve conceived based on my experience in 2008 and implemented during the volatility of 2020. I trust it will be worthy of consideration for those of you who struggle with how, when, and if you should be buying into a bear market. I’ll answer the three questions raised above in specific bullet sections below.Buying into a bear is tricky. How should we be managing our investments during a time of market uncertainty? Click To Tweet
A Strategy For Buying Into A Bear Market
Back in 2008, I shot all of my “Dry Powder” too early in the bear market. Trying to catch that falling knife drew blood as the market continued to fall, but fortunately, the wound healed in time. More importantly, I learned a lesson. With the bear market and volatility we’re facing now, I developed a new approach. Below, I share a strategy for buying into the bear that also addresses questions on when and how to rebalance during a volatile market.
While the bear has retreated a bit from his rampage in March 2020, he’s still lingering. Best to have a plan before he comes with his next attack.
Let me state upfront my sincere compassion for folks who are struggling today. There are millions of people impacted by the Coronavirus, and many are on the brink of financial ruin. Add the 300k+ deaths globally, and it’s a difficult time to write about financial planning. As I wrote in “When Money Doesn’t Matter”, it seems insensitive to write about financial planning in times such as these.
And yet, we still have an obligation to manage our portfolios.
Should I ignore the topic, or is there value in addressing how we should handle our investments in spite of the suffering? Suffice it to say, I’m trying to balance two very delicate issues, and I trust you’ll take this post in the sensitive manner in which it is intended.
We’re in a time of above-average volatility, and it’s an appropriate time to discuss a strategy for buying into a bear market.If you're struggling with buying into a bear market, today's post will be of interest. Click To Tweet
Q1: Should we have a strategy for buying into a bear market?
Yes. Whether we realize it or not, we all have a strategy for dealing with a bear. We either ignore it and let things ride, or we take a more hands-on approach to take whatever advantage we can from the realities of a volatile market. In a worst-case, some panic and sell. No one should retire without a strategy for how they’re going to manage volatility, a strategy that should be prepared before the volatility strikes. I’ve written several previous posts on how to manage a bear market, linked below for your reference:
- The Benefits of a Bear Market
- 6 Steps to Avoid the Looming Bear Market
- Resilience in the Face of Market Volatility
- 5 Moves I’ve Made in Today’s Volatility
Today’s post is different.
Today I’ll be sharing a strategy I implementing for the first time in March 2020. It complements the previous bear market posts with a specific tactical approach that automates the rebalancing process in the midst of market volatility. Ironically, I saw the quote to the left from Vanguard’s CEO as I was doing my final edit on this post. It’s a positive reinforcement to have Vanguard cite the importance of rebalancing, and it strengthens my opinion that this strategy makes sense for certain situations.
Disclaimer: This strategy is not intended as a recommendation. Rather, I am simply sharing my decision on how I’ve decided to approach market volatility. I don’t know your situation, and my strategy may not be appropriate for you. Please consider this strategy as simply a case study rather than a specific recommendation for you.
The 5% Rebalancing Strategy
When the market started dropping in February, I started paying close attention. Typically, I don’t look at our financials very often. I only update our Net Worth once a year. I run through our Annual Financial Checklist every January, and I automate our monthly paycheck. I’ll refill Bucket 1 several times throughout the year, and do occasional spot checks on our Asset Allocation. Beyond that, I prefer to focus on the more enjoyable things in life.
When the bear came out of the woods earlier this year, however, I implemented a plan I’d been thinking about for some time. The actions I’ve taken are summarized in the following chart, where the red circles show the dates I executed trades and was buying into a bear market, selling cash/bonds to fund the transaction. I’ll explain my strategy below:
As you can see, I’ve been buying consistently during the downturn, and have stopped buying as the market stabilized. What was my process for deciding when to pull the trigger?With the 5% Rebalancing Strategy, I simply move 1-2% of my portfolio from cash/bonds into stocks with each 5% downward move in the S&P 500. Click To Tweet
The strategy is simple. With every 5% move down in the market, I rebalance an amount equal to 1-2% of my portfolio from cash/bonds into stocks. The simplicity of the above strategy appeals to me in several ways, as summarized in the benefits listed below.
The Four Benefits of the 5% Rebalancing Strategy
- It automates purchasing decisions, removing emotion from action.
- It automatically rebalances when stock allocation drops below target.
- It provides a system to “buy low”.
- It avoids shooting all “dry powder” too early in the bear.
Let’s look at each one of the above points in detail:
Benefit #1: It Automates The Purchasing Decision
First, I must state that I started this strategy with an excess of cash/bonds. As I shared in my Annual Financial Update in January 2020, I was 8% “over-weight” in cash/bonds at year-end and looking to shift some money into equities during the year. The cash in Bucket 1 is excluded from this strategy. If you’re starting in a position where you’re under-weight equities, this strategy could be worth your consideration. The advantage of this strategy is that it automatically establishes triggers for when I should be buying into a bear market.
“If the stock index of choice drops by 5%, I automatically shift 1-2% from cash/bonds into equities.”
Given my objective of increasing stock holdings, I established the 5% Rebalancing Strategy as my approach. As the bear came out of the woods, I waited patiently and began buying into a bear market via tranches when each new 5% downward move was hit. Initially, I made smaller moves, with the first move of 0.3% of my portfolio executed on Feb 25th, followed by successive tranches as shown in the chart above.
As the bear deepened, I increased my tranches to 1.5% – 2% of my portfolio, culminating with a 2% rebalance from cash/bonds into stocks on March 23rd, the low point of the market to date.
Rather than being anxious during the bear, I simply took a screenshot of the market data on the date of my latest trade and waited for a 5% further decline. I actually began looking forward to further declines and the opportunity to execute my next tranche.
Having a plan to automate my purchases made the ability of buying into a bear market stress-free, and took the emotion out of the situation. Benefit #1 achieved.
Benefit #2: It Automatically Rebalances Stock Allocation
The second question I raised in the introduction was this:
- Q2: When should we rebalance, and should it change in the midst of volatility?
At a minimum, I develop a rebalancing strategy once a year when I do my Year-End Review. However, I do tend to increase my frequency when the markets get volatile. When the stock market drops quickly, your asset allocation follows suit. If stock prices drop while bonds/cash hold steady, you’ll see your stock allocation declining as a % of your asset allocation. Depending on your sensitivity to asset allocation, more frequent rebalancing in the midst of high volatility may make sense for you.
An example is in order. The following Asset Allocation Impact simulation uses actual VTSAX data as a proxy for the S&P 500, and demonstrates the impact of falling equity prices on your asset allocation.
A 5% decrease in equity value shifts asset allocation by 1% (assuming a 50/50 portfolio):
Assumptions: $1M portfolio, 50% Equity (VTSAX), 50% Cash/Bonds. Cash/Bonds assumed to be stable for simplicity.
If we assume a 1% rebalancing from cash/bonds to stocks is executed per the 5% Rebalancing Strategy guidelines, you can see the Asset Allocation “corrects” from 51/49 to 50/50, maintaining our targeted asset allocation during the bear market:
As I shared in my Annual Financial Update post, it’s critical that retirees establish a process for rebalancing, a point which is best illustrated with this chart from M. Kitces:
As the bear market continued, I stayed true to the new strategy and executed rebalancing trades throughout the drop as previously shown. Here’s a chart I made to explain the strategy on my Twitter Account:
By the depth of the bear on March 24th, our hypothetical VTSAX account (after rebalancing at each 5% tranche) would be as follows:
By looking at the cash/bonds line, which drops from $500,000 to $422,000 you can see we’ve rebalanced a total of $78,000 and increased our shares in VTSAX from 6,274 to 7,540 shares. In spite of those moves, we’re still holding close to our 50/50 target. Had we not done the rebalancing, our equity allocation would have fallen to 41%.
Thus far, we’ve concluded that we should have a strategy for managing a bear market, and we should have a process to ensure we rebalance when appropriate. The 5% Rebalancing Strategy accomplishes both objectives, along with the following advantages:
Benefit #3: It provides a system to “buy low”.
Using the 5% Rebalancing Strategy forces you to continue to buy as the market declines. It eliminates (most of) the anxiety of the bear, and ensures you continue to buy lower and lower as the market declines. The interesting thing is what happens when the market rebounds. I updated my VTSAX scenario in late April for the ChooseFI podcast, and it gives a glimpse of what the impact will be if/when the market recovers:
As the market rebounds, you begin to see the value of “buying low”. The shares you purchased during the decline start making gains, in spite of the fact that the price of VTSAX is still lower than your starting point. In fact, the $20k (2% of $1M) that you purchased on 3/23 is now up 26%, from $54.49 to $68.92/share. At some point in the recovery, you’d begin to rebalance back toward cash as your equity allocation exceeded your target. I’ve set a range of 60% maximum for my “ceiling” on when I’ll start selling the equities and moving back into cash/bonds, with the plan on rebalancing in either direction (as dictated by the market) to maintain my targeted range between 50 – 60% in stocks.
How does it impact performance?
If we compare the 5% Rebalancing Strategy to the “Do Nothing” strategy over the same timeframe, you’ll see the action has resulted in a 1% improvement in portfolio performance.
While the “market” (VTSAX) has declined 13.5%, a 50/50 beginning portfolio would have declined 6.8% if you’d done nothing. By implementing the 5% Rebalancing Strategy, your portfolio would have declined only 5.8% and your period ending net worth would be $9,231 higher, at $941,657. (Again, assuming no movement in cash/bonds to simplify the example).
Benefit #4: It avoids shooting all “dry powder” too early in the bear.
As mentioned earlier, I bought too early in the 2008 bear. After years of a bull market, a “small” move downward can feel bigger than it really is, and it’s easy to get trigger happy about buying some stocks too early. Knowing that bears can drive a market down 30 – 50%, it’s better to have a system that automates your decision on when to buy-in. If we assume a 50% decline, the 5% Rebalancing Strategy would execute rebalancing trades throughout, assuming your targets were established based on the amount of dry powder you were hoping to invest. Rather than invest too much too early, your moves are automatically triggered by each successive 5% downturn.
In fairness, it’s also possible that the strategy will keep you from buying all that you “should have” with the wisdom of hindsight. Since it limits your trades to 1-2% of your net worth per 5% move, it avoids the temptation of “buying big” when you “feel” the market is near its bottom. To me, the tradeoff of having a system in place is worth the cost of potentially retaining too much dry powder when the market rebounds.
Obviously, each individual could modify the 1-2% trade amount (as well as the 5% trigger movement) to suit the strategy to their own risk profile. A higher trade amount per trigger would burn through the dry powder more quickly, though it could also cause your asset allocation to deviate beyond your targeted range. I chose the “1% per 5%” target based on my objective of not having my stock allocation fall below 50%, and it achieved that objective. I wasn’t trying to time the market, I was simply seeking a more strategic approach to rebalancing during a time of increased market volatility.
This brings us to the third question we asked at the beginning of this post:
Q3: What should we be doing to manage our investments during a time of market uncertainty?
Each of us must decide for ourselves how we want to manage our investments during market volatility. What’s important is that you have a strategy in place prior to the bear’s arrival. As long as the system you’ve chosen is consistent with your investment philosophy and risk tolerance, it will prevent you from making poor decisions when things start getting crazy.
Potential Improvements – Compliments of The Money Guy Show
I’ve been a big fan of The Money Guy podcast since well before my days of writing this blog. I was honored to appear in a Money Guy YouTube episode (The Secrets of Successful Retirement Savers), and consider Brian Preston and Bo Hanson as friends. I was talking with Brian recently and mentioned my 5% Rebalancing Strategy to him. We had a great chat about the strategy, and he provided some professional insight worth sharing:
- The strategy could be especially useful for someone who is seeking to invest a lump sum (e.g., bonus windfall money), but is concerned about investing it “all at once”. While Dollar Cost Averaging (DCA) is a viable alternative, the 5% Rebalancing Strategy could be used as an “accelerator” in conjunction with DCA. Essentially, you’d establish your automatic investment schedule, then accelerate as the triggers in this strategy are hit. Great thought, Brian.
- If you prefer to avoid actively monitoring your portfolio for the initial tranche, you could wait to implement it until a bear market (20% decline) has been announced. A big advantage of the strategy is how it takes advantage of a limited window of opportunity, and this advantage could still be leveraged with adjustments to the starting point (for reference, I started with the first 5% decline in the market).
I’m pleased that I asked Brian for his thoughts, his professional input is credible. It’s always possible to improve on a strategy by brainstorming with professionals in a given field (note, I’ll do the same with you at the end of this post).
Personally, I’m pleased with the results thus far with the 5% Rebalancing Strategy. It’s early in the game and I’ll continue to monitor performance. If the market continues to recover, I’ll implement a similar strategy to begin selling 1% tranches of stocks as my asset allocation increases beyond the 60% stock target. If the market takes a turn for the worse, I’ll continue following my strategy, using a 5% decline from the March 23rd bottom as my next rebalancing tranche. Even Big ERN is trying to figure out if the Bear is over and the Bull has returned – the nice thing about the 5% Rebalancing Strategy is that it should work well regardless.
It’s been a useful strategy for me. I thought it worthy of sharing with you.
- Smart Strategies for a Bear Market by Investopedia
- Here’s What You Should Do Instead of Panic Selling by Doughroller
- Rebalancing Portfolios In A Bear Market by Financial Advisor
Implementing the “5% Rebalancing Strategy” has provided me a systemic approach for buying into a bear market. By rebalancing 1% of my portfolio for every 5% correction in the stock market, I’ve been maintaining a steady asset allocation, buying low, and strategically putting my dry powder to work as the market declined. As the market has begun to recover, I’m seeing benefits from buying stocks while they were on sale, with a 26% return achieved within one month on the shares purchased at the depths of the bear. Increasing my rebalancing frequency in the midst of market volatility has achieved my objectives while improving my overall return compared to the “Do Nothing” approach.
Should the market continue to improve, the strategy will be complemented with a similar, but opposite rebalancing approach of selling shares equal to 1% of my portfolio for every 5% improvement in the market (triggered when my stock allocation hits 60%). In the meantime, I’m continuing to count on the bucket strategy to provide cash liquidity to meet my spending needs, while avoiding selling equities in the midst of the bear market. In all likelihood, the initial “sell” tranches on the rebound will be used to refill the cash I’ve pulled from Bucket 1 through the first four months of the year. If the market fall resumes, I’ll look to continue drawing down on my three years’ worth of reserves in Bucket 1, potentially refilling it with some bond or gold sales later in 2020 or 2021 if necessary.
Your Turn: Did you have a strategy for managing the bear that appeared earlier this year? If so, what was your approach? What are your thoughts regarding the 5% Rebalancing Strategy? How could we improve it, together? Let’s chat in the comments…