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How to deal with an uncertain market: Diversify, relax, rebalance, repeat

Andrew Hallam is the index investor for Globe Investor's Strategy Lab. Follow his contributions here and view his model portfolio here.

The U.S. stock market has risen 47 per cent in less than two years. The international market is up more than 33 per cent and the Canadian index has risen about 25 per cent. If you're adding money to the markets, you should be disappointed. I am. I prefer to see sinking markets.

We can't control stock market movements. But those adding money to stocks should much prefer dropping or stagnating levels. Few investors understand this. Rising markets are great for retirees. But they're a pain in the butt for those collecting assets. Warren Buffett agrees.

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Celebrating rising indexes is like gushing about the rising prices of canned goods at your local supermarket. Of course they'll rise over time. But stocking up when they're cheap is better than buying during a bull run.

Many investors understand this, but still feel a strong desire to try timing the market. Some investors figure that if the markets have had a great year, say, gaining 20 per cent or more, it might be time to sell. "Such returns aren't normal," they might say, figuring normal returns run between 9 to 11 per cent a year.

But returns landing precisely within this range aren't normal at all. Between 1926 and 2013, U.S. stocks gained between 9 and 11 per cent just three times. In 1968, they gained 11 per cent; in 1993, they gained 10.1 per cent; and in 2004, they earned 10.9 per cent. The rest of the time, stocks soared, sank or sputtered.

U.S. stocks averaged 9.92 per cent between 1926 and 2013. But single year performances were unpredictable. On 24 occasions, U.S. stocks recorded annual losses. Stocks gained 25 per cent or more during 24 other calendar years.

International stocks prove the same paradox. Over long time periods they too averaged returns between 9 and 11 per cent a year. But few individual years recorded profits within this range. During my lifetime, it has happened twice. Global stocks gained 10 per cent in 2005 and 9.6 per cent in 2007.

Canadian stocks hardly differed. They gained between 9 and 11 per cent annually just three times during the past 38 years: 10.1 per cent in 1976, 9.8 per cent in 1977 and 9.8 per cent in 2007. Returns exceeded 25 per cent during eight calendar years.

So how do we deal with wild fluctuations and massive gains? It isn't easy. Experts are always forecasting the next market plunge. If you read and listen enough, your head will spin on a swivel as experts call for contrasting action.

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There's an easier way to deal with the markets. Close your ears, your eyes, and maintain a diversified portfolio. Once a year, look at your allocation. If either stocks or bonds have significantly risen or fallen, simply rebalance. Such is the case with the Strategy Lab portfolio of indexes that I created nearly two years ago. This time last year, stocks had increased dramatically since the portfolio's inception. So I sold some of my stock indexes and added to bonds, simply bringing my portfolio back to its original allocation.

I started with roughly a third of the portfolio in Vanguard's Canadian Short-term Bond ETF; roughly 38 per cent in Vanguard's FTSE Canada Index ETF; with the remainder invested in a U.S. index, developed world international index and an emerging market ETF. There's no magic formula to the perfect allocation because nobody can see the future. But by keeping costs low and diversifying, you can reap what the stock and bond markets offer. What's more, when rebalancing, you're adhering to one of Mr. Buffett's mantras: being a bit greedy when others are fearful and fearful when others are greedy.

Once again, stocks have done well during the past 12 months. So once again, my portfolio is out of alignment. To fix it, I've simply rebalanced. I sold some of my most profitable indexes (U.S. and international stocks), adding the proceeds to my bond index.

Investors adding regular sums to their investments can rebalance without selling. They would simply look at their goal allocation and purchase the lagging index each month. It's not exciting. And you won't be able to brag about your latest stock pick or mutual fund around the summer campfire. But with a diversified, rebalanced portfolio of index funds you won't get burned if you're patient.

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