In a prior post, we likened market volatility to going to the dentist: unpleasant, but ultimately good for you. Volatility brings with it opportunities (often lower stock prices, for example), and is really just the price investors pay for solid long-term returns.
That said, there are some ways to reduce your portfolio’s volatility to let you sleep better at night. Let’s look at a few of them.
Imagine that all your investments were in one stock. One month your portfolio could be up 10%, and the next month it could fall by the same percentage. All your eggs would be in one basket, and the fluctuations might be extreme. Needless to say, that’s not diversification. But what if your holdings were comprised exclusively of stocks in one industry? Your eggs would be in a number of baskets, but those baskets would tend to rise and fall together. So much for diversification.
Meaningful diversification involves owning assets that are “uncorrelated”: in other words, securities that don’t move in lockstep with one another. And this can help to limit the volatility of your portfolio. It’s a point underlined by Ben Carlson, who looked at the historical gyrations of U.S. and emerging market stocks. From 1998 to 2018, his figures show that emerging markets and U.S. equities exhibited nearly identical performance, but the former had twice the volatility along the way.
Yet Carlson shows that, assuming annual rebalancing, a 75% U.S./25% emerging market equity allocation increased returns, but with volatility that was not far above what a 100% U.S. portfolio would experience. The lesson: smart diversification can limit volatility and may actually increase returns.
Play Some (Simple) Defense
One straightforward way to limit your portfolio’s volatility is just to be more defensive. That can mean increasing your cash weighting somewhat. You may also choose to own more fixed income investments, which tend to be less volatile than equities.
Of course, all bonds are not created equal, and the same is true for equities. You can also reduce your portfolio’s volatility by selling a bond of lesser quality (and usually higher yield) for something like a government bond, which probably pays less but is considered safer. In a similar fashion, switching out of growth stocks in favour of more defensive shares can cause your overall portfolio to decrease (but be prepared for your returns to be lower).
Rebalance as Needed
Some people may think that the lesson of long-term “buy and hold” investing is that you don’t have to do any tinkering with your portfolio. If only things were so easy. As one asset class outperforms another, you will occasionally need to “re-balance” to get your desired weightings back in line. For example, if you started with a 60-40 equity/bond mix, a rising stock market might have caused the value today to be more in the 75%/25% range. To rebalance, you would sell some equities in favour of bonds. You’d be sticking to your plan, and reducing your portfolio’s volatility in the process.
Who can be against that?