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NEW YORK (MainStreet) —Investors should rebalance their portfolios based on the volatility of the market to increase the gains in their retirement portfolio.

Following a timetable of rebalancing quarterly or even twice a year results in having investors missing gains and take on the losses of a particular sector, said Matthew Tuttle, the portfolio manager of Tuttle Tactical Management U.S. Core ETF (TUTT) . Focusing on volatility helps investors keep more of their winning stocks while selling the losers.

“In traditional portfolio construction, volatility is assumed to be static, and today's volatility is viewed as tomorrow's volatility,” he said. “Targeting portfolio volatility is a much better approach.”

This strategy calls for investors to rebalance by the market and not follow the traditional method of maintaining the same stock and bond allocation. An investor with a portfolio consisting of 60% of stocks and 40% in bonds would have to sell his winners and buy their losers if their stocks rose to 70% of their allocation because of gains in the market. A tactical rebalancing strategy calls for investors to stick with their winners and purchase an even greater percentage, Tuttle said.

Volatility should not be viewed as a negative factor since returns do not always decline when the asset’s volatility increases.

“At the end of some horizon, the investor has earned as much as reasonably possible while being able to tolerate the ride,” he said. “When volatility is high, the ride is bumpy and becomes much less tolerable.”

Volatility is often an investor’s biggest ally when markets are rising and on the upside, said Robert Johnson, president of The American College of Financial Services in Bryn Mawr, Pa. Stock market volatility has been at an all-time low and reached a new record in 21 years in June when eight weeks occurred without a single-day change of more than 1% in the S&P 500, a benchmark index.

“In fact, since the start of the year, the S&P 500 has traded in a narrow range of approximately 6.5%,” he said. “While such consistency may help investors sleep at night, it is difficult to build wealth when securities trade within such a narrow range.”

During the next 12 months to five years, the main driver of the market will be the Federal Reserve and how swiftly it increases interest rates, said Patrick Morris, CEO of New York-based HAGIN Investment Management. When interest rates rise, volatility will follow suit.

Tracking volatility can be difficult for average investors, but choosing to invest in certain assets will “pay when volatility rises,” he said.

“In theory, rising volatility is bad for stocks and for that matter, most asset classes," he added. "It tends to show a lack of directional conviction and it often ‘blows out’ to the downside.”

Both iShares and ProShares are exchange-traded funds which offer volatility-related products and products tied to the VIX, the volatility index. Purchasing a substantial allocation to a VIX-linked product should help diversify against market volatility, Morris said. “Managing volatility will always reduce return since you are intentionally reducing the portfolios risk profile,” he said. “If you have 35% of the portfolio in a VIX-linked product, a good strong rally in the market will be muted in your portfolio and it might be by more than the allocation would suggest.”

Rebalance your portfolio according to your original mix of stocks and bonds to avoid allowing increased market volatility “push you into trying to time the markets,” said David Walters, a portfolio manager with Palisades Hudson Financial Group, a Scarsdale, N.Y. financial services company.

“When rising markets lead to an over concentration in one asset class, you should reduce your stake in it,” he said.

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While rebalancing at fixed intervals such as quarterly or annually is beneficial, the time period can be too long and can “leave a portfolio severely out of balance between rebalances if they're too far apart or incur unnecessary trading costs if they're too frequent,” Walters said.

Following an acceptable range of deviation from a portfolio's asset allocation, such as within 5% to 15%, means an investor can take advantage of “market movements in a disciplined way that focuses on long-term outcomes, not short-term volatility,” he said.

“Calendar rebalancing” lacks value, because it “completely ignores how much your portfolio has drifted from its target asset allocation,” said Ajay Gupta, CEO of Gupta Wealth Management, a San Diego financial advisory. 

Investors should only rebalance only when the risk and return profile of the portfolio has changed “significantly enough to warrant the transaction costs and potential capital gains,” he said.

“This approach will trigger more rebalancing in volatile markets and less during times of prolonged stability, but the key driver is how the asset classes fluctuate in relation to each other,” Gupta said.

Rebalancing Yearly or Quarterly

The old tried and true method of rebalancing your portfolio once a year is a better strategy for most investors to limit the tax consequences, said Kyle Ryan, head of advisory services at Personal Capital, the Redwood City, Calif.

“The key is to have a system and stick with it,” he said. “Our research has shown that rebalancing annually is appropriate and provides more overall long-term benefit than other methods.”

While there are many schools of thought about rebalancing a portfolio, the critical point for investors is to choose one which “creates discipline and removes emotion from the process,” said Brian Burmeister, senior portfolio consultant with Schwab Private Client Investment Advisory in San Francisco.

Reducing volatility in a portfolio can be accomplished by maintaining a diverse mix of assets despite current market conditions, said Adam Morgan, a senior investment advisor at PNC Wealth Management in Pittsburgh. All stocks and bonds along with commodities contain a degree of volatility.

“Volatility affects those different asset classes at different times and to varying degrees,” he said. “Investors concerned over market fluctuations may make short-sighted adjustments that can cause them to miss the long-term opportunity in market recovery.”

Following a strict policy of maintaining a strategic asset allocation and rebalancing towards it helps investors, said John Fattibene, director of financial planning for Harvest Financial Partners in Paoli, Pa. and a portfolio manager at Covestor, the online investing marketplace.

“You are almost mechanically making yourself do what everyone says they try to do – buy low and sell high or at least relatively high and low,” he said. “We look at rebalancing and portfolio diversification as the closest thing to a free lunch in the investment business. It may be yawn-worthy, but we love beautifully boring investments and investment strategies.”

Maintaining a diversified portfolio can be just as important as rebalancing your assets, said Greg Vigrass, executive vice president of Folio Investing, a McLean, Va.-based online investing platform. A lack of diversity could cost an investor “massively or 30% to 50% of potential lifetime returns,” he said.

“If you’re invested in just a few securities or funds, you’re almost certainly under diversified,” he said. “When the market is booming, investors buy and when they think the market’s in trouble, they sell. Investors chase high-performing funds, hot stocks and fads.”