Should I rebalance my portfolio when the stock market is crashing?

For the first time in months, US equities almost went into full correction mode. While valuations are still very high, many portfolios will have felt the pain. That’s because most portfolios will follow a common asset allocation strategy split between equities and bonds. Equities are viewed as the riskier assets but also the more rewarding ones. Bonds, on the other hand, are meant to be safe assets with bond prices rising when people are looking for safety. This is a bit of a generalization but the principle stands.

Those portfolios suffered from a double whammy in the past two weeks: first, we had falling bond prices due to various macro circumstances such as a higher U.S. deficit and a tightening of the Fed policy resulted in higher bond yields. This scared equity investors, which led to a widespread decline in equity valuation. Money is getting more expensive to borrow, which means that companies used to cheap money will see reduced profits unless they can offset higher financing costs with higher revenue and profits. The US economy is already booming and US businesses are benefitting from the Trump tax cuts so it’s hard to see how much profit growth is left for grab.

 

It’s tempting to have the urge to do something and make the situation better. Nobody likes to see the value of one’s portfolio plummet by 5% or even 10% in a week. Our instincts tell us that we must act, at least to mitigate losses.

 

Like most things in life, it is a matter of what you intend to do and when you intend to do it. While I believe that most people should do nothing and avoid emotional moves, there are still a few situations where it is fine to rebalance your portfolio or take corrective measures.

 

When is it acceptable to review the asset allocation of your portfolio during a stock crash?

 

Extreme volatility in your portfolio

If your portfolio is made up of options or derivatives, then it is time to at least review the positions. There is nothing wrong in speculating to capture abrupt price movements like the ones seen this week to make a profit. If implemented properly, the results will dwarf what you could have made with shares alone. The least you could do however is to understand how the instruments that you are buying and selling are priced. For example, options have four primary drivers: current stock price (of the stock on which the option is based), intrinsic value (the difference between the strike price and the stock price), time (or theta) and implied volatility (IV).

It is important to understand how volatility works. If the market expects a “hot” stock such as Tesla or Tilray to move drastically until expiration, this increased volatility will have to be priced and will also impact the time value of the option. An option’s time value increases when there is strong volatility due to the uncertainty of the stock price until expiration. In other words, a stock price that tends to move significantly is harder to predict.

Implied volatility is determined by the current price of an option contract on a particular stock. Think of it of the unknown factor caused by market participants guessing the final stock price. When the uncertainty related to a stock movement increases, the option price is traded higher because IV has increased. However, when there is less uncertainty in determining the price of a stock, IV will decrease.

 

As the moves of this week were very sudden, more people have been trying to reassess the outlook of stocks (ability to rebound, anticipated earnings, macro conditions etc). Overall, the price of options has increased due to higher IV. In short, more people are guessing in different directions with multiple outlooks. As there is no consensus on the price of a stock, the implied volatility increases, which causes the price of the option to increase.

 

If the IV has significantly increased on the price of the options you hold, it is time to evaluate your positions. If you had call options, those are likely to have lost significant value. If you had put options, then well done (assuming you bought them recently). If you are thinking of buying call options to capture the technical rebound, be mindful that you are not the only one thinking of this play. Even if you are right, you will need a higher price movement than usual in the right direction because the IV will have increased (and everybody is buying options at the same time to benefit from the same strategy). Look at how the VIX index – commonly referred to as the index of fear – has increased recently. This index is literally based on the price of options.

 

This why certain options can decrease a value after earnings, even if the earnings positively impacted the underlying stock price. A lot of people would have predicted the right price movement, overinflating the price of the option, and then everybody would sell at the same time a few days later.

 

Quarterly or monthly review of your asset allocation

It is acceptable to review your asset allocation and make changes to your portfolio if you had already intended to do so. If this review was not prompted by plummeting stock indices, then you are fine as you are only following your pre-established strategy. Similar to not making emotional moves during a period of high volatility, you should stick to your old habits and continue reviewing your portfolio as usual.

 

It turns out that this bit of a volatility started early October. Early October also happens to mark the beginning of the last quarter of the year, and the end of the third one. If you are in the habit of reviewing investments every quarter, or even every month, then it would have made sense for you to review the performance of your portfolio at that time. If you decide to make a few tweaks to readjust the risk profile of your stock allocation, then this is fine. The point is that you are not reacting to an event or series of events. You are simply checking in, as you would have with or without volatility.

 

Speculate and greed

“Greed, for a lack of a better word, is good” said Gordon Gekko.

 

If stocks across all industries are down 10%, then it is natural to hunt for bargains. Some of those stocks may have been rightfully re-priced but it is also likely that some stocks are just following the trend without any material changes to fundamentals. For those stocks, it might make sense to buy them at a discount. If the fundamentals are right, there is a limited risk and a significant upside.

The strategy is risky as it amounts to timing the bottom of the dip. If the dip turns into a recession, then it will take months or years to recover. Catching a falling knife requires a bit of luck and when markets start panicking, there is no way to tell when the end is in sight. Ideally, you will only do this in your Yolo account. If you are using your main portfolio or worse, your pension pot, then make sure that you are invested for the very long term.

 

It is not a terrible idea to make a one-off pension contribution to your pension pot if you still have not maxed out your annual allowance (or you believe that you won’t have maxed out your allowance by the beginning of the next fiscal year). Again, you are trying to time the dip but as you are investing for the very long term, the risk of error is less relevant. Also, the one-off contribution will be topped up by at least 20% and can even result in additional tax relief for higher-rate and additional-rate taxpayers.