Balancing Volatility and Value

This year will be another challenging year for investors. With expectations that interest rates will continue a downward trend and an economy which has slowed much more quickly than many expected, the stock market is very likely to remain volatile for a very long time.

We have a new President, slowing economic growth and a stock market that has given back significant gains over the past year. The volatility of stock prices is a well-know phenomenon to all investors, but has become a little more extreme in recent years.

Many of us are having a real difficult time dealing with the anxiety created by the lack of predictability of this market. This is truly a market where we have to keep reminding ourselves that the fundamentals of investment are more important than ever.

We all dream about investing our money and being able to watch it grow at a steady 9% or 10% year after year. Unfortunately, this kind of return isn't available today without taking significant risk. But there are things you can do to help protect your portfolio from the market's gyrations and keep yourself on track to meet your long-term investment goals. Let's examine two key questions:

What is Volatility?

Most people don't really understand what volatility has to do with risk. Targeting high returns means you may become 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. 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 fluctuates over time and it is measured by something we call the standard deviation.

For now keep in mind 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 10 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 like 2000 when bonds actually do better than stocks or 1999 when bonds actually lost money or became a higher risk. Which leads to my next topic.

What about 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.

Differing Styles

And here is one of the most important aspects of investing in stock mutual funds that is the manager's style of investing.

This means that the portfolio manager has an investment philosophy that he follows to select the stocks in his 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.

These managers did very well with a focus on technology in 1999 but have suffered many losses in 2000. Value managers are looking for good companies that are selling at a "bargain" price because of unrecognized underlying value or maybe the company is growing a little slower than its peers.

Over time many value funds have held utilities, energy and financial companies. In recent periods they have held pharmaceuticals that had been beaten up in the high-flying tech market. The value funds have definitely been some of the top performers in 2000 while they were some of the worst performers in 1998 and 1999.

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 value 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 and more volatile 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 and trying to time the market, you will miss out when one category or style has its best performance.

All-in-all, 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 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). It does pay to buy some of that boring stuff along with the exciting growth funds.

Keep your portfolio diversified and you will balance volatility with value, stabilize your performance, and hopefully, sleep much better at night.