How Can I Protect My Portfolio From Volatility?

Answer...

Here are some things you need to know and understand:

• The meaning of the term market volatility.
• What causes volatility in different asset categories?
• The real value of diversification.

Allocating your portfolio’s assets or deciding what type of investment assets to hold in your portfolio will be the single most important investment decision you make in reducing or controlling volatility.

What is Volatility?
Most people don’t really understand what volatility has to do with risk. Targeting high returns means you may become very good friends with high risk and high volatility. Volatility is a measure of how much the returns and the value of your portfolio go up and go down and up and down. You get the general idea.

Sometimes financial markets like recent ones can almost make you seasick. This volatility or the risk of your portfolio is measured by just how much your portfolio goes up and down over time and it is measured by something we call the standard deviation. In order to make sure you don’t fall asleep reading the rest of this article, I will not provide a detailed explanation or calculation at this point. However, remember that standard deviation is a measure of risk. Another measure of risk is how many times you wake up in a cold sweat at night thinking about your portfolio when the market starts making wild moves either up or down.

In general, over longer time periods, bonds have lower returns with lower risk. Shorter maturity bonds (two or three years) have lower yields than longer maturity bonds (seven to ten years). Stocks normally provide higher returns with higher risk. There are many categories within stocks such as large cap companies that are more stable with lower expected returns and small cap companies with higher expected returns and higher risk. Foreign stocks can be even more volatile than domestic small cap stocks. Of course, there will be times when bonds actually do better than stocks or may even become a higher risk. Which leads to my next topic.

Asset Diversification
You probably already know the difference between a bond and a stock, but did you know that these are just broad categories? Even among bonds, which you might generally think of as a "sure bet investment," you can invest in high-yield bonds or international bonds that can be just as volatile if not more so than some stocks. There are government bonds, municipal bonds, corporate bonds, asset-backed bonds and on and on. But don’t let all the categories stop you. You don’t have to understand all the bond categories in order to invest in basic bonds or bond funds. Mutual funds can be a great way to invest your portfolio in many types of bonds that fit your investment plan.

You may think of all stocks as "risky" but did you know that some of the larger, blue chip company stocks could provide a stable stream of income just like a bond? Of course you do have more aggressive stocks – like the small-company stocks, technology stocks or international stocks. Most stocks are grouped into the following general categories: Large-cap, mid-cap, small-cap. And over time, each category has had (and will have again) its performance beat the others. The key is to spread your dollars over several categories, including bonds, in order to reduce the overall volatility of your portfolio.

Style Diversification
Another aspect to be aware of when investing in mutual funds is the manager’s style of investing. This means that the portfolio manager has an investment philosophy that they follow to pick the stocks in their portfolio. The main styles are growth and value.

Growth managers are looking for companies that are growing at a faster rate than other companies in their industry or sector. Value managers are looking for good companies that are selling at a "bargain" price. Some mutual fund managers blend both styles when picking stocks. Over time, both styles have had periods of time where they have done well and where they have performed poorly. In recent periods, the growth style of investing has been out performing everything else. But be prepared for when the tide shifts - and we know it will shift at some point!

Your Time Frame
A very important factor in reducing your volatility is your time frame. If your goals are short-term (less then five years), you need to avoid the more aggressive investment and stick with money markets, CDs and short-term bonds. If your goals are longer term, you may have very little allocated to bonds and be more heavily weighted in stocks that will increase your potential return and your potential risk and volatility. The best strategy is to always look to the longer term and stick with your allocation. If you are constantly chasing performance by changing your allocation you will miss out when one category or style has it’s best performance.

Remember that you want your portfolio to meet your investment goals over the LONG term. There is no glory in chasing the hottest stock or the hottest fund. And we all know that no one has a crystal ball when it comes to predicting what will happen in the financial markets. So allocate your portfolio over the asset categories (government bonds, municipal bonds, high-yield bonds, large-cap stocks, mid-cap stocks, small-cap stocks, etc) and investment styles (growth and value). Keep your portfolio diversified and you will dampen the volatility, stabilize your performance and portfolio value, and hopefully, sleep much better at night.

by Diahann W. Lassus, CFP^®, CPA

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