Amidst the worried debate over whether the United States will tumble into recession this year, market watchers agree on one thing: volatility is here to stay.

Even if policy makers in Europe solve the debt crisis swiftly and their U.S. counterparts come to agreement on how to handle this country's own debt woes, Wall Street expects markets will continue to gyrate unpredictably. After the last few years, markets are so spooked that even serious improvements from both sides of the Atlantic are unlikely to restore equilibrium, strategists say. That means advisors should prepare by taking a fresh look at risk, and build in allowances for increased volatility in client portfolios.

But being prepared for volatility does not have to mean hunkering down in a financial bunker with piles of cash and bonds. Several strategists have counseled advisors that while they should be respectful of volatility, they should still embrace it.

A recent white paper entitled "The Great Global Shift: New World, New Rules," argues that investors should think as much about risk management as maximizing returns. This means advisors have to be flexible, dynamic, and think globally, according to Lisa Shalett, a co-author of the paper and chief investment officer and head of Investment Management and Guidance for Merrill Lynch Wealth Management. In a webcast that accompanied the paper, Shalett said that the way Wall Street is thinking about risk management is evolving. At one time, risk management was about diversifying—often among a small set of traditional asset classes: stocks, bonds, cash.

But today, advisors and clients should also think about diversifying to asset classes that are not correlated to what's already in the portfolio. That means commodities, currencies, real estate and other alternative investments. Shalett noted that need for non-correlation partially explained the recent wild popularity of gold, as investors clamored for safety as many asset classes began to move downwards in tandem.

Regardless of whether the metal is a true storehouse for value, Shalett predicted it could "continue to play an important role in people's portfolios simply because it is negatively correlated with so many other asset classes that had become tightly correlated." Shalett added that this new kind of thinking is what investors should bring to the traditional buy-and-hold, set-it-and-forget-it mentality. "I don't think we're living in a decade of set it and forget it," she said. She suggested the annual rebalance should be happening more like two or three times a year.

Rebalancing Act
Dean Junkans, chief investment officer for the Wells Fargo Private Bank, agreed, saying that "buy and hold" hasn't been "buy and hold" among the most sophisticated clients for some time, but "buy and manage." Rebalancing "adds more value than a lot of people realize, especially if done in a volatile market environment," Junkans says.

There have traditionally been two schools of thought on when to rebalance. The first is to do it only once a calendar year. The second is to do it when the strategic allocation mix of assets has crept a certain percentage away from the target mix, say 5% to 7% off course.

Junkans believes it's best to keep the mix from straying too far from its target, and if that means multiple rebalances a year, so be it.

Jeff Applegate, chief investment strategist at Morgan Stanley, says his team constantly monitors "portfolio drift" and rebalances whenever asset allocation moves out of a pre-set range. "There's no set periodicity to it because there's not set periodicity to how markets move."

Junkans notes that in the last three years the managed products his group uses have needed multiple rebalancings during a 12-month period. A third way to do it is a combination of the two: look at the portfolio every quarter, and rebalance at that time. Of course, no Wall Street strategist is suggesting that buy-and-hold is completely dead and that the new order of the day is surfing waves of volatility like a day trader. The traditional wisdom still holds that in calm and turbulent times alike, a thorough financial plan is an investor's foundation.

And a big part of that foundation is still a long-term asset allocation plan. "It's important to have enough of a long-term view so that you're not moving in and out of things all the time," Junkans says. He advises making "adjustments" to the portfolio, "dialing up and down risk in the portfolio as we see opportunities."

But once advisors are accustomed to more frequent portfolio changes, and even if clients are comfortable, Junkans counseled keeping the adjustments modest. No sweeping changes, like leaping to 50% cash. "If you're wrong, it can screw up the portfolio from a long-term perspective," he says.