I’m a big fan of some of the behavioural finance work being done, which
includes studies by Vanguard’s own investment strategists and analysts.
A lens on investor behaviour
For example, in January our Investment Strategy Group introduced a “risk
speedometers” report to look at how investors are reacting to market
developments. This lens on real-world behaviour measures the risk investors
are taking in a given period by calculating the difference between net cash
flows into higher-risk assets such as equities, and net cash flows into
lower-risk assets such as U.S. Treasury securities. The measures are then
compared with long-term averages.
In the spring, our risk speedometer spiked. The rise was fueled by
investors’ decisions to direct more of their money to equity investments in
developed and emerging markets and to riskier bond credit categories.
A spiking speedometer seems a fitting analogy for what can happen when
one’s guard is down. I consider myself a responsible driver. Still, when
the highway is clear and the weather is nice, I might glance down at the
speed gauge and find that my foot has gotten a little heavy.
The same phenomenon is possible with an investment portfolio. Just as our
attention can drift from our speed (and our risk level on the road),
investors can neglect the risk level of their portfolios’ asset
allocations. Experience teaches that investors are especially prone to lose
sight of risk when markets have been buoyant.
How I manage risk in my own portfolio
Rebalancing is one of the best ways I know of to help manage risk. Without
rebalancing, a portfolio may end up potentially riskier than intended and
no longer aligned with the investor’s goals.
I have a ritual I perform every June and again each December, between
Christmas and New Year’s, as I prepare for a series of annual meetings with
the Vanguard crew. I’ll set aside some time, review my investment
portfolio, and, if necessary, rebalance back to my target asset allocation.
My own portfolio is a mix of equity and fixed income funds, and I invest in
both actively managed funds and index funds. Most years, I’ll make a minor
adjustment to get back to the appropriate asset allocation for my own
longer-term goals and risk tolerance. It’s not all that complicated,
although my portfolio is a little more complex than some because I own more
funds than we’d typically suggest. (As chairman, I feel I should own a
significant number of Vanguard’s funds.)
Consider your options
You should consider rebalancing if your target allocation is off by 5
percentage points or more. Admittedly, this is often easier said than done.
When an investment has performed exceptionally well, people have a hard
time trimming it. They can be led astray by an old (and none-too-helpful)
investing maxim: Let your winners run.
Fortunately, in recent years we’ve seen all sorts of investors take steps
to rebalance. Many of the endowments, foundations, and traditional pension
plans that Vanguard serves have good processes built into their investment
guidelines to make sure rebalancing takes place on a regular basis. And
among investors enrolled in defined-contribution retirement plans, more and
more are using target-date funds, in which rebalancing happens
If you choose to rebalance on your own, use your target asset allocation as
your guidepost. Don’t be afraid to buy into bad news. In a sense, don’t
worry about the noise of the marketplace. If you work with an adviser, make
sure he or she understands the importance you place on your rebalancing
And remember, the goal of rebalancing is to manage risk, not to avoid it
altogether. Risk is inherent in investing – we just want to bear that risk
That insightful memo on risk I mentioned earlier included a saying often
attributed to the American humorist Will Rogers: “You’ve got to go out on a
limb sometimes because that’s where the fruit is.”
F. William McNabb III is Chairman and Chief Executive Officer of Vanguard Group Inc.
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