If I can translate what you are saying, all else equal expected returns are higher during periods of low volatility than during periods of high volatility.More or less. In the first place, short-term volatility usually doesn't rise during periods of high realized returns, generally it falls. Volatility itself, as well as implied volatility (Black-Scholes) generally rises during periods of highly negative realized returns.Just so folks aren't misunderstanding your position (it took me a while to figure out what you meant), you intend that the opposite of decreasing your allocation during high volatility to mean that you shouldn't do anything. Correct?
One can do one of three things when that happens: nothing--ie, not rebalance; rebalance back to policy; or "overbalance," ie, increase the policy allocation. All three of those things are reasonable. What's *not* reasonable is to use the Merton Share formula, which is to lower one's allocation, which would mean selling an asset after price falls.
From that standpoint, it seems to make sense that one would be justified in using a strategy that (i) converts a portion of the ballast assets into equities during periods of low volatility to take advantage of the higher expected returns and (ii) takes the profits from that additional allocation when volatility gets large again.
In essence, the second step is simply your suggestion of rebalancing back to policy.
Is your distaste for the Merton Share formula based on the behavioral thing that one has to keep at it?
From a math sense, using allocations based on inverse variance or inverse volatility allocations holds together. When I test out the idea using ~100 years of data, it tends to smooth out the sequence of returns by reducing the big hits without much sacrificing long-term returns compared to holding the same assets with the same average allocation fixed over time. I'll just note that a smooth sequence of returns is especially important in decumulation, usually less so in accumulation.
The smoothing effect is much more dramatic when using simulated 2x or 3x LETFs, which are a tool that investors are increasingly using. Generally speaking, volatility and thus rebalancing frequency would be proportional to the square of the leverage factor, so are much more important than with standard index funds. Instead of annual or multi-year rebalancing, one may need to rebalance several times a year on average.
I personally find it quite reasonable to adjust allocations using inverse variance or inverse volatility for the portion of my portfolio that uses 3x LETFs, especially since rebalancing is occurring fairly frequently anyway. I expect that this application is outside the zone where the rules of thumb that have developed in personal finance are fully applicable.
Statistics: Posted by Hydromod — Tue Nov 19, 2024 6:19 am