This post was originally published on this site
Did retirees and soon-to-be-retirees suffer in vain during the February-March waterfall decline?
I’m referring to their having to endure the COVID-19-induced bear market, which caused the S&P 500 SPX, +1.15% to drop by 34% from its February high. The almost-universal advice during that plunge was that we ignore it and hold on for the long term.
But did we really need to suffer that many sleepless nights? Few stop to ask, since this advice is so widely accepted as gospel. In this column I nevertheless ask this perhaps sacrilegious question.
The inspiration to challenge to conventional wisdom comes from a major academic study that appeared a year ago in the Journal of Financial Economics by finance professors Alan Moreira of the University of Rochester and Tyler Muir of UCLA. They found that investors can increase their long-term returns by as much as 2% annually by reducing their equity exposure whenever volatility starts to rise—and only increasing it again once volatility starts to come back down.
Read: The nursing home COVID-19 tragedy — how did this happen?
What a revelation. For years we were told that our emotions are our worst enemies, and that we need to resist the urge to sell when volatility spikes. This new research suggests the opposite: That—at least in this regard—our emotional urges lead us in the right direction.
Moreira, in a recent interview, explained how this approach might work: At the end of each month, compare the volatility of the stock market’s daily changes in that month to what it was in the preceding calendar month. If it’s higher, then reduce your equity exposure in the subsequent month. And if it’s lower, increase your exposure. (For a simple short cut, he said, you can focus on the VIX VIX, -5.41% ; comparing its month-end level to what it was at the end of the previous month.)
Moreira said that a rule of thumb he thinks is appropriate for long-term investors is to have a default equity allocation of around 80%, which is high but not so high as to stand in the way of increasing it even more should volatility decrease sufficiently. At the beginning of this year, he said, this portfolio’s equity allocation was close to this default, but was already much lower than that by the time March rolled around. It thereby sidestepped the bulk of the bear market.
Read: Social Security’s future just got darker
For example, this portfolio’s equity allocation would have been lower in February than in January, since volatility increased in January—from a VIX of 13.78 at the end of December to 18.84 at the end of January. It would have been lower still in March since the VIX jumped to 40.11 by the end of February. And it would have been still lower in April, since the VIX closed March (at 53.54) even higher than February’s month-end reading.
This hypothetical portfolio never goes short the market, or even to 100% cash. But at its lowest point earlier this year, Moreira said, this portfolio’s equity allocation was around 10%. If retirees and soon-to-be-retirees had been following this portfolio allocation, they would have slept a lot more easily through the dark days of March.
Note carefully that if you follow this strategy outside of your tax-deferred retirement accounts there will be tax consequences for the short-term trades. So long as you utilize it in tax-deferred accounts, however, that is not a concern.
Why volatility timing works
You may wonder how it can be that generations of academic researchers and financial planners missed the potential of volatility-managed portfolios. Moreira believes it traces to a failure to distinguish between spikes in volatility, which are short-lived, and increases in the market’s long-term potential, which are longer-lived. Because of this difference, he and his co-researcher write, “investors can avoid the short-term increase in volatility by first reducing their exposure to equities when volatility initially increases, and capture the increase in expected returns by coming back to the market as volatility comes down.”
I note in this regard that volatility has come down from its record levels in March. At the end of April, for example, the VIX was 36% lower than where it stood at the end of March. Followers of Moreira’s research therefore would have increased their equity exposure at the beginning of May. They wouldn’t have increased it all the way back to the default allocation of 80%, but at least they would have begun the process of tiptoeing back into the market.
This part of the volatility strategy may be more difficult to execute from an emotional point of view, since the tendency after a market crash is to stay away from the market for longer than is warranted. But the strategy’s long-term potential requires that you nevertheless do so.
If you don’t have the discipline to do that, then you shouldn’t bother, sticking instead with your previous long-term buy-and-hold strategy.
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. Hulbert can be reached at mark@hulbertratings.com.
