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How To Prepare Your Income Portfolio For Volatility


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Has it really been only nine years? On March 6, we celebrated yet another anniversary of the current bull market. This bull, having recorded a better than 300% return from the closing low of 666.79 set on March 6, 2009 (not counting dividends), is already in the running for the longest such run in history.

However, this comparison to the bull markets of the past brings out fear of a pending bust. There have simply been too many instances where bear-market selloffs followed bull-market rallies. The "dot-com" crash, for instance, came at the end of the massive 12-plus years 1990s bull market (when stocks jumped by more than 800%).

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The 50% or so decline of 2008-2009 also came at the end of the 2003-2008 bull market, during which the S&P 500 index more than doubled. Moreover, because of the size of that decline and the fact it's only been nine years since the market trough, that selloff still feels very much alive in our collective memory.

No wonder investors have mixed feelings about this market: We are extremely happy to participate in the gains but remain ever fearful about the possibility of a loss.

Why You Shouldn't Be Worrying -- Yet
The return of volatility in early February has triggered some unpleasant memories.

The VIX -- the volatility index or "fear index" -- jumped to levels not seen since 2015. Even though market volatility since then has ebbed, it remains elevated compared to the one-year average.

Still, it's a far cry from the fear the market experienced during the last bear market. While the February volatility jumped as high as 50 as measured by the VIX, by comparison, in October 2008, we saw readings as high as 80. The fact that stocks have calmed down after the February scare is encouraging, and it also signals that investors aren't finished with this bull market just yet.

Moreover, there is really no need to be afraid of the current level of volatility.

First off, it's only elevated compared with the past year, and we should not be getting used to the market going up without pausing. Furthermore, by itself, volatility is part and parcel of a well-functioning market -- a market in which long-term investors feel comfortable while still being able to pick up a potential portfolio holding at a periodic "sale." Even bear markets -- for those with a long enough investment horizon -- have proven to be great buying opportunities with the entire market going on sale.

Still, you never know where the market is going and how long it's going to be there. This is true for both the bull and the bear markets -- nobody can time the entrance or exit points with any certainty. And the longer the bull market keeps going, the more the investors -- especially the ones already in or approaching retirement -- begin to think about portfolio safety and the preservation of gains.

What You Can Do Today
One time-tested method to enforce portfolio resistance is rebalancing.

The jury is still out on the subject of whether or not periodic rebalancing aids the overall performance of a portfolio. The uncertainly here lies in market timing -- the end results will depend on the point of entry, the actual points of rebalancing, and the market direction. For instance, with this nine-year bull market, stock investors have greatly benefitted, while the performance of bond portfolios, on average, has lagged. Buying more bonds while selling stocks (what rebalancing would call for when stocks overperform bonds) this time around would have resulted in a weaker performance.

But what experts agree on -- and what I think is the key reason to rebalance -- is that rebalancing is a relatively simple tool that helps weather the volatility when it comes.

Let's take the stocks-bonds example above. A hypothetical investor who started a 50-50 stocks-bonds portfolio in March 2008 and didn't rebalance along the way would now have a 74-26 portfolio, which might not be the risk he or she is willing to take at this time, especially considering our hypothetical investor is now nine years older.

But if this investor's risk tolerance has improved, not deteriorated, he or she might be ready to put up with the higher portfolio risk that comes from a larger equity stake. This is why all rebalancing decisions -- as well as all other investment decisions -- are quite personal.

However, as a rule, rebalancing brings a portfolio what has gotten away from the original allocation plan back to the intended allocation. And this is why rebalancing is a tool for controlling portfolio risk.

Indeed, the main rationale for rebalancing is that it can help reduce a portfolio's volatility level. Most experts recommend either annual rebalancing or target-based rebalancing (when a portfolio gets away from its target allocation by a certain amount -- most often it's a 5% or 10% goal, in which case smaller fluctuations can be ignored).

Your Source For The Most Stable Income Stocks
As some research indicates, this time may be different when it comes to balancing out the extra volatility. Unlike in years past, many previously uncorrelated or low-correlated assets have begun trading more in sync.

Even if there is no asset that will jump as volatility surges, different assets would still react differently to higher volatility. Plus, "risky" assets, such as stocks, are more likely to be more volatile than, say, a "safe haven" like bonds, especially high-quality bonds. (Volatility reflects price swings, and those are likely to be wider for stocks than for bonds.)

Moreover, many investors practice rebalancing between various sectors of the market. Here, valuation comes into play.

Of course, cheaper sectors and stocks may be cheap for a reason. Sometimes current price, as enticing as it might be, reflects well-justified market pessimism on a particular stock or sector and anticipation of low or declining profit growth, or an outlook for flat or declining dividends. To avoid value traps, make sure you do your homework on the assets you plan to buy more of, just like you do your homework for assets you plan to open a new position in.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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