How to take advantage of the randomness of portfolio returns

Yes, you heard right -- assuming that you have a diversified portfolio that matches your risk tolerance and risk capacity, your portfolio returns are random! (Well, in a manner of speaking -- and a very useful one at that.)

Now this may sound distressing, but it's actually a good thing for your peace of mind and not a bad one for your financial plan. Knowing returns are random means that -- hopefully -- you can see portfolio downturns as natural events and not personal failures, and more importantly, you can plan for how to take advantage of them!

Ready? Let's go.

Yes, portfolio returns are random

One of the foundational aspects of Modern Portfolio Theory is that diversified portfolio returns can be relatively well-modeled by using a random distribution . Now, people will argue as to whether that distribution is Gaussian (normal, "bell curve") or not, and about the skewness and kurtosis and exact shape of the curve, but the fact remains that there is a lot of randomness in portfolio returns, especially on the stock side.

And this is to be expected: insofar as public markets are efficient, you should expect there to be nearly no discernible real patterns -- the only time prices should change should be when new, unanticipated information enters the system. Again, people will argue about just how efficient markets are, and the validity of "technical analysis", etc., but no one will argue that there isn't a lot of noise, and that it's difficult to disentangle actual patterns from noise that just happens to look like a pattern.

Therefore, it's an imperfect but quite useful analogy to think of market returns like dice rolls: you'll get 7's more often than other results, but you'll also get 2's and 12's, albeit rarely. The stock market has had a down quarter about 27% of the time since 1976 or so; that's roughly equivalent to rolling two dice and only losing if you roll a 5 or lower (my combinatorics nerds out there can check, but by my math the odds of rolling 5 or lower are exactly 10/36) -- and let's say 4 or lower if you add bonds to the mix, which will help in some (but not all) market downturns.

So investing in a diversified portfolio is like rolling a pair of dice dozens and dozens of times, and each time making a small bet that you'll roll a 5 or higher. You can afford to lose any given bet (because you're betting dozens of times, and because you've got enough cash for short-term needs), and the odds are in your favor, so why not make the bet?

If you think of it this way, suddenly investing becomes a lot less stressful. All you have to do -- all you can do -- is create a diversified portfolio that matches your risk tolerance and risk capacity. Then you just roll the dice.

Here's the important point: assuming all this -- that you're making a series of small bets, with the odds in your favor, each of which you can afford to lose -- no matter how the dice come up on any roll, this was a wise decision. You made a bet that the number would be higher than 4, and it came up 2 last time? So what? Dice are random; this is what happens. It doesn't suddenly make sense to start betting on 2 just because that's the last number that came up, does it? Did the laws of probability suddenly change? If not, then why change your bet -- why not continue to bet on 5-or-above, since the odds are in its favor?

This is where people trip up -- they say, "oh man, I should have seen that 2 coming and changed my bet!" No, you shouldn't. Public markets are efficient enough -- the dice are random enough -- that constantly trying to change your bet is a loser's game (see Burton Malkiel and any one of a number of other researchers). You can't control the dice; all you can do is bet the good odds. You'll still win over time, even if you have an occasional loss -- and changing your bet just lowers your odds of winning over time.

...but are the dice are loaded?

Now, continuing the analogy -- which, like all analogies, is imperfect, but useful in this case -- you might wonder if the dice are loaded, particularly on the stock side of your portfolio. Should you just use a low-cost, all-in-one total world stock fund like VT? Or can you tilt the odds even more in your favor, by placing a side bet on the numbers that the dice are weighted towards?

A lot of ink has been spilled -- and continues to be spilled -- in answering this question. I've spilled a bit myself, and for now, I'll just direct you towards this article on the "investment factors". But for purposes of this article, it doesn't necessarily matter whether you have a "factor tilt" in your portfolio or no; I'm just mentioning it in passing so you know that I'm not ignoring the issue entirely!

What can you do with a natural 1?

Speaking of dice games: do you play Dungeons and Dragons? Have you ever set up the perfect action, that spell or attack that would be so cool in this particular scenario, and you've stacked bonus on top of bonus in order to maximize the odds of success...only to roll a natural 1 on your 20-sided die, which means an automatic failure? I have, and it's incredibly frustrating! (And if you don't play D&D...well, give it a shot! If you read this blog, I think you might like it, and right now it's more popular than ever!)

But when the market has a downturn, as painful as it is, that doesn't actually mean there's nothing you can do. And no, I'm not suggesting you "pull everything out of the market until it goes back up"; unless you're quite lucky, that's a recipe for disaster, as the folks who went to cash in March 2020 found out to their dismay!

So what can you do? Among other things, consider opportunistic rebalancing and tax-loss harvesting.

Opportunistic rebalancing: buying low

If there's a large market downturn, it's quite likely that your portfolio's asset allocation has gone seriously out of whack -- what was formerly a 75% stock/25% bond portfolio may be down to 65% stocks/35% bonds! This is an opportunity to bring it back to its nominal allocation; by selling bonds and buying stocks, you have an opportunity to "sell high" and/or "buy low". At the very least, by increasing your stock allocation from e.g. 65% to 75%, you're increasing the expected returns back to your target!

Now, if you're doing this in a taxable investment account (normal brokerage accounts, not 401(k)'s, IRA's, or HSA's), you have to be careful, because this can have tax consequences -- and generally speaking, opportunistic rebalancing means selling the "winners" to buy the "losers", so it's quite common! You'll need to use your judgment to determine whether the proverbial "sell high" juice is worth the "realized capital gains" squeeze.

Note, however, that if you're in the "accumulation phase" -- you're making regular contributions to your investments -- then you can simply do "cash-only rebalancing": rather than selling the winners, you can just use your regular contributions to buy whatever your portfolio needs most of (generally, what's gone down the most recently). This isn't really opportunistic rebalancing per se, as a market downturn won't affect the timing of the purchase (because you're not trying to time the market...right?), but it's something to be aware of when you're wondering What Can I Do?

Tax-loss harvesting: defer ye taxes while ye may

If you have taxable investments, you can also take the opportunity to sell assets that are worth less than what you paid for them, and thus give you a "realized capital loss" that you can then use to offset taxes now and/or in the future.

Again, I'm not recommending that you sell your "losing" investments and go to cash; rather, I'm simply recommending that you take the opportunity to defer some taxes to a later date, letting more of your portfolio grow tax-free for longer.

For example, or you could take the opportunity to optimize your portfolio -- sell some sub-optimal, legacy assets you bought a long time ago, and purchase a more efficient fund (perhaps one that has more of a factor tilt).

Or you could simply sell some assets at a loss and buy a similar-but-not-identical fund, leaving your portfolio roughly the same as it was, modulo those deferred taxes I mentioned.

Or you might be able to use this as an opportunity to do some opportunistic rebalancing without having to pay taxes on the rebalance (though see above: generally speaking, in a rebalancing scenario the assets that lost value are the ones you want to buy more of).

Now, to get a bit into the weeds here: when you look at your portfolio to see if you can do some tax-loss harvesting, be aware that just because your overall cost basis (the calculation of the total price you paid for an asset) is lower than the current value, it doesn't mean that there isn't a tax-loss opportunity! For example, let's say you have 1000 shares of VT. Maybe you bought 500 shares 10 years ago, and another 500 last year. Even if on average you've made money (which is almost certainly true), it might be that the 500 shares you bought last year are worth less than what you paid for them, in which case you could tax-loss harvest just those shares, and maybe e.g. buy some DFAC instead.

But do I have to?

To be clear -- you don't have to engage in tax-loss harvesting or opportunistic rebalancing. Sure, they'll likely help put more money in your pocket, but it's far from a make-or-break if you have better things to do. (And if you're reading this, you probably have better things to do!)

I know tech professionals, though -- we just itch when something happens over which we have no control. So here I want to (a) reiterate that downturns are natural and okay, and don't reflect a failure on your part, and (b) offer you something productive to do to scratch that itch!

Of course, if you'd rather have someone else focus on these and other portfolio optimizations so you can focus on more important things, you know where to find us!

Britton is an engineer-turned-financial-planner in Austin, Texas. As such, he shies away from suits and commissions, and instead tends towards blue jeans, data-driven analysis, and a fee-only approach to financial planning.