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.

Shalett said these more frequent portfolio revisitings should be linked to very specific goals and very specific timelines for those goals.

Volatility Isn't the Enemy
Another new aspect of risk management is recognizing that volatility doesn't have to be the enemy. Just as international value investors have always preached investing when there is blood in the streets, strategists suggest viewing volatility as a way to uncover opportunities. Think of the times of dislocation as the perfect time to upgrade all aspects of a client's portfolio: quality, growth and yield.

And strategists say advisors should not think of going shopping only domestically. The siren song of global investing has been sung for years now, but observers say many advisors and investors have still not heeded it. Applegate says that in his experience, most advisors are U.S.-centric.

Shalett said Merrill has done studies showing the average client has just 3% of their wealth exposed to emerging markets. Certainly, these markets historically have been unstable places, often with opaque transparency and limited shareholder rights.

However, the story is changing, as these things slowly improve. Plus, demographic trends favor these countries and their economies are growing, with a rapidly expanding middle class. That's where about two-thirds of the world's economic growth is coming from.

Developed markets on both sides the Atlantic are projected to notch below 2% growth next year. Yet the global estimate is still around 4% because emerging markets are projected to grow between 4% and 6%. So what happens if these volatile economies swoon? That's where the dynamic approach of more frequent rebalancing comes in.

But even after embracing dynamic portfolio management, analysts say advisors must have a well-defined process for opportunistically taking on this extra risk.

That's because clients' risk appetites are as fluid as every other variable in the market, according to Tyler Cloherty, analyst at Cerulli Associates, who recently authored a report called "Hitting a Moving Target." In it, he noted that advisors are good at managing the quantitative inputs, adjusting risk and return to match long-run projections.

But, even if the advisor can use quantitative models to measure risk, changes in the portfolio's riskiness are often influenced by client willingness to take on more risk. That is often clouded by collective panic or exuberance, laying the groundwork for fuzzy decision-making.

"To accurately determine situational client reactions, behavioral traits must be incorporated," Cloherty wrote. He notes that Barclays Wealth has started to do behavioral finance profiling of clients along with the initial risk profile. That can help give an advisor a better picture of what the client will look like when the markets are in a very different place than they are at the time of the questionnaire.

Knowing the client's likely behavior beforehand is helpful, but the most critical thing, not matter how often the advisor rebalances, "is to describe the potential outcomes and potential risk in those movements up front," Cloherty says. "And staying true to your process over the long term is critical. Don't move to cash or get overly risky during times of exuberance just because of psychological factors."

Beyond that, Cloherty says, having a well-defined process for measuring risk is essential. If an advisor has a dedicated investment specialist, that's ideal. But if not, he likes the idea of largely outsourcing the management of client risk to the wirehouses' research and investment committees. These teams give guidance on strategic allocation for a variety of risk levels. They also highlight tactical weightings for each asset class. Most are aiming to identify opportunities within a six- to 18-month time frame.

"If the advisor wants to allocate their time to spreading out the Wall Street Journal and thinking great ideas, like overweighting emerging market bonds, more power to them," Cloherty says. "But for the average advisor, where 80% of their time is dedicated to client development and managing their own client base, the resources are not adequate enough to manage a global portfolio. It makes more sense to default to the firm research team."

Cloherty says that wirehouses have reported these programs have been popular, advisors asking for more over the last two years. He believes the wirehouses could do more in terms of risk controls, which he said are "pretty minimal" because they want to let the advisors have as much flexibility as they can "without creating a compliance nightmare." Still, he says, they should have more risk controls to aid inexperienced advisors in portfolio construction.

Finally, even with all of the sophisticated new software to measure risk, many observers still believe that the most potent tool for managing risk is already in advisors' toolboxes: diversification. "From the get-go you need to start out with a diversified portfolio with non-correlated asset classes," Applegate says. "That's the best way to spread risk."