Three ways you can ‘own’ volatility
Do you want to reduce volatility? You’re not alone. Volatility management is a common goal among investors. The assumption is that volatility is always a bad thing. If left unchecked, volatility can certainly do damage to your portfolio. However, volatility doesn’t always have to be a bad thing. The key is in how you manage it.
A portfolio that has zero volatility would have no chance for loss. But it would also have very little or no chance for return. A bank account is a perfect example of a low-volatility investment. Banks offer minimal levels of interest. It would be nearly impossible to beat inflation with such a low-volatility investment.
On the other end of the spectrum, a portfolio of small- or micro-cap stocks in countries with emerging economies could offer extremely high levels of return. However, that type of portfolio would also be exposed to the potential of substantial levels of loss. The returns may be high, but the volatility may be as well.
The key is to find a portfolio somewhere in between the two options. Eliminating volatility completely also eliminates the possibility of return. Embracing volatility too much can bring excessive levels of risk.
So, how can you make volatility work for you instead of against you? These three steps can help you take control of your portfolio:
1) Diversify. Diversification is the first and most important step toward controlling volatility and making it work in your favour. Diversification is based on the concept of correlation, which is how related two assets are in terms of volatility.
For example, two investments that have a correlation of 1.0 will always move in the same direction. If one investment goes up by 10 percent, the other will, as well. The same is true if one investment goes down by 10 percent.
On the other hand, if two investments have a correlation of -1.0, they’ll move in opposite directions. Investments that have a correlation of zero have no relationship to each other.
When you diversify, you want to allocate your money across a large number of asset classes that have low correlations to each other. When the large-cap stock portion of your portfolio is going down, the international bond portion may be going up. When bonds aren’t generating much return, stocks may be on the upswing. Spreading your assets around reduces the risk that all of the asset classes in your portfolio will go down at the same time.
The important thing is to diversify in a way that is consistent with your risk tolerance. If you’re conservative, you may want to overweight low-volatility assets such as high-quality bonds. If you’re more aggressive, you may go heavier in stocks and international investments. An investment adviser can help you find your risk tolerance and the appropriate investments.
2) Dollar cost averaging. Dollar cost averaging is a terrific way to manage volatility. More people should take advantage of it. In a dollar cost averaging plan, you contribute a fixed amount to your portfolio on a regular basis — monthly, for example. The contribution then goes into a predetermined allocation of investments.
Dollar cost averaging is beneficial in a couple of ways. First, it gets you in the habit of regular saving, which is always a good thing.
However, dollar cost averaging also reduces volatility. Because you’re contributing the same amount each month, the number of shares/units you buy of each investment varies depending on the investment’s price. When values are high, you buy fewer shares/units. When values are low, you buy more.
For example, let’s say you put £400 into a fund every month. During one month, the fund is priced at £10 per unit, so you buy 40 units. The next month, the fund is priced at £8 per unit. That month you can buy 50 units.
In this process, you are buying fewer shares when they’re priced high and more shares when they’re priced low. That means your overall cost per share will be reduced, which means that a drop in value won’t hurt your portfolio too much. In fact, a drop could help you, because you’ll be able to buy more shares at lower prices.
3) Take the long view. Often, the biggest problem isn’t volatility itself but rather how investors react to it. Far too often, investors take a decline in value as a sign that they should sell, when it could, in fact, be a great buying opportunity. They may get frightened about a sharp decline in value and bail out of their investments altogether.
While those feelings are understandable, they only serve to turn a potential loss into a real one. In many cases, it would be wiser to hold and wait for the market to turn. One way to stay disciplined is by knowing one’s time horizon and taking the long view.
If you’re saving for retirement and it’s still decades away, short-term volatility shouldn’t be much of a concern. You can probably afford a little volatility in order to get higher returns. As you approach retirement, you can shift your allocation into more conservative investments, thereby sacrificing higher returns to avoid excessive volatility.
The best way to manage this process is by working with a knowledgeable and experienced investment adviser. He or she can help you better understand your time horizon, determine your risk tolerance, and select the appropriate investments. The adviser can also set up a dollar cost averaging program to help you make volatility work for you.
If you’re concerned about volatility, don’t quit on investing altogether. Instead, talk to a trusted professional and he or she can help you manage volatility and take control of your financial future.
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Blog published by Mike Coady