The Opposition of Staying-the-Course and Doing Nothing

Barring any dramatic market swings in the final two weeks of 2020, we will experience the greatest calendar-year stock market recovery in history. On March 23, the S&P 500 was down 33.9% from where it started the year. As of December 14, the same index was up 13.5% in 2020 – representing a trough-to-peak gain of 64%. Chalk up another record for the year that is 2020.

There are plenty of lessons to be learned – or just to be reminded of – from this year. Among the valuable reminders is that doing nothing in the midst of sharp market losses (or gains) is negligent and irresponsible.

What’s that you say? You thought investment fiduciaries long preached a buy-and-hold approach that avoids market timing as the tried and true path to long-term financial success. Don’t such fiduciaries usually discourage market-timing? Did 2020 change that?

Nope. Still 100% advocates of a long-term, buy-and-hold approach. It is, however, requisite to understand that the long-term, buy-and-hold mantra is not a do-nothing strategy. It is a stay-the-course strategy. There’s a big difference between letting the wind take you wherever it will and readjusting the ship’s direction to maintain the targeted course. This is a fundamental but misunderstood concept of prudent buy-and-hold investing.

Consider that there are really three broad approaches to volatile markets:

1) Do nothing

2) Stay the course

3) Change the course

The change-the-course strategy is a market reaction strategy that historically has the worst results of the three. It is the equivalent of turning the ship around because of unexpectedly strong winds as if we did not anticipate that there would be difficult conditions along the way. Dignified investors who reduce risk in the midst of losses tend to label it as “going to cash until things settle down” or a more professional sounding theme like “market-based hedging”. Whatever it is called, 2020 produced another stain on the track record of the change-the-course strategy that sells stocks amidst market losses. And while 2020 was unique in a number of ways, it was not unique here. Four times during the past decade, the stock market suffered a drawdown of more than 15%. In all four of those instances, stocks quickly reversed and had fully recovered all losses within 138 trading days.

What about the do-nothing strategy? Consider the case of Rudolph in 2020. He started the year with 60% stocks (iShares All Country World Index ETF) and 40% bonds (Vanguard Total Bond Market) and did absolutely nothing – resulting in a 2020 gain of 10.8% (through December 14). Contrast this with Rudolph’s mentor, Vixen, who used rebalancing rules to apply a stay-the-course strategy to his investments. When the stock allocation departed the 60% target by more than 10% in either direction (54% / 66%), Vixen immediately rebalanced back to the 60% target. Employing this stay-the-course approach meant that he rebalanced investments on March 16 to buy stocks and on June 8 to pare back his stocks. Diligently setting the ship back to course during the choppy markets resulted in a return of 13.5%.

In sanguine times, there is little or no difference between staying-the-course and doing nothing. They are effectively one and the same. But when the stock market experiences a year’s worth of volatility in a few hours or posts several of the 20 most volatile days in stock market history as it did in March and April 2020, there is distinct opposition between staying the course and doing nothing.

Case in point: just 56 trading days into 2020 – and without any corrective rebalancing – Rudolph’s do-nothing portfolio that started as 60% stocks and 40% bonds became 50.6% stocks and 49.4% bonds. Whereas Rudolph started the year with 20% more in stocks than bonds, the two allocations were nearly equivalent by mid-March.

Lessons Learned from 2020

There are a lot of lessons to learn from 2020. But keeping to the topic of investing and market volatility, here are a handful of the fundamental takeaways:

1. Staying the course does not mean doing nothing. When a target investment allocation is established, it will immediately deviate from target as the market moves. It is practical to let the allocation drift from target within reason. Letting the allocation drift materially off course as occurred for nearly all investors in 2020 without any correction (rebalancing) defeats the purpose of even having a target in the first place. It is the functional equivalent of setting sail from New York to London but letting the wind redirect you to Senegal without correcting course.
2. 2020 provided a textbook case for the benefits of rebalancing. We covered a simple 60/40 example above but the results were similarly beneficial regardless of the targeted stock/bond allocation. The uniqueness of 2020 was that because of the dramatic intra-year volatility, the rebalancing benefits played out over a very short window of weeks rather than over years.
3. One of the primary reasons that disciplined rebalancing works is because it contra-trades relative to human emotions. Rebalancing inherently reduces risk when risk premiums are low (fear is low) and adds risk when risk premiums are high (fear is high). The profits from rebalancing come from the bulk of individual investors who do the opposite – trade based on emotions (buying when perceived risk is low, selling when perceived risk is high) rather than trading based on a discipline.
4. 2020 provided support of “tolerance band” rebalancing as optimal to calendar rebalancing. Tolerance band rebalancing is simply a disciplined approach like the one employed by Vixen where allocations are allowed to fluctuate within tolerance bands but when they “break the bands”, the allocations are rebalanced back to targets. Alternatively, calendar rebalancing tends to rebalance once a year on a preset schedule, regardless of intra-year volatility. In a year like 2020 where there is dramatic intra-year volatility, once-a-year calendar rebalancing often fails to extract the significant benefits of rebalancing. An investor who simply evaluates her portfolio every December would find roughly the same allocation in December 2019 as December 2020, losing out on the intra-year rebalancing premiums. While there are varying methods to apply Vixen’s tolerance band rebalancing approach, the evidence demonstrates that any reasonable form of his approach is optimal to calendar year rebalancing.
5. Annual rebalancing is practical but suboptimal. For individual investors who do not have time to regularly monitor their allocations, calendar rebalancing is a reasonable balance between optimization and practicality. For advisors who charge a fee to monitor and manage portfolios, there is really no excuse in the Internet age to maintain a legacy calendar rebalancing approach in light of all the benefits of tolerance band rebalancing and the pervasive technology to perform it.

Have questions, comments, or general thoughts on the concepts above? Please use the comments section below to share.