5 Ways to Reduce Investment Volatility

If you are an investor, you know how difficult it is to tolerate investment volatility. It’s not unusual to experience day after day of multiple 100 point swings in the major indexes – from one direction to the next.

That kind of movement can throw you right off your investment horse. More than one person I know has found that kind of volatility simply intolerable. As a result, some investors throw in the towel and keep their money in the bank. By doing so they lock in losses, give up all chance of growing their money to combat inflation and (in many cases) forfeit a comfortable future because they don’t have the best investments to create retirement income. That’s a pretty expensive tradeoff. How can you keep investment volatility at bay?

1. Stay Away from Sector Funds

You may be 100% convinced that gold, oil, China, (fill in the blank) are the investments of the future. You might even be right. But if you expect narrowly focused sector funds or ETFs to be void of volatility you are barking up the wrong tree. The more narrowly you invest your money, the greater the fluctuation you’ll experience. The reverse of this is also true.

Highly diversified funds tend to smooth out your investment ride. Make sure your funds sport a good mix of a variety of investment sectors and risks. There will be times when very defensive industries (such as utilities and consumer staples) do well. Then, before you know it, the market will rotate and favor other industries such as technology, energy and commodities. If you want a hands-off strategy that reduces market volatility, make sure your funds are highly diversified in a variety of industries.

2. Learn Your Latin

Funds are rated by “beta.” This measures how much your fund fluctuates compared to the market (as represented by the S&P 500). Let’s use an example. Let’s say you do a little investigation upon evaluating your mutual funds. You pour through the reports and learn that the beta of your fund is .84. That means for every 1% change in the S&P 500, your fund historically moves only .84%. If you buy funds with a .5 beta, they would fluctuate only half as much as the S&P 500 (on the up and downside). The lower the beta, the lower the volatility.

3. Be Sensitive

If you are a regular Wealth Pilgrim reader, you already know that I am a huge fan of using market timing strategies to reduce risk. The idea is to invest in the strongest funds and only when the market itself is strong. Conversely, when the market demonstrates weakness (according to the criteria measured by the strategy) funds are sold and cash is raised.

This strategy I use is not designed to always maximize gains. Rather, it’s structured to reduce portfolio volatility over the long run. This strategy has its pros and cons like any investment approach, and there are many ways to use market timing. And like any investment strategy, there can be periods when investors are disappointed. But for the right person, this can be a good way to keep the market from rocking your investment boat.

4. Asset Allocation

Asset allocation is yet another way to smooth out your investment performance. This is really just an expansion of the first point of not investing narrowly. But asset allocation takes this idea and really leverages it. Asset allocation involves investing in a variety of investment classes – not just equities. That means bonds (domestic and international) and commodities in addition to equities of all sizes and nationalities.

The typical asset allocation model rebalances the account periodically. You start off by having set percentages in a variety of asset classes. When any one particular asset class has done exceptionally well, you sell off a small amount to bring it back to the set percentages. You take the proceeds and buy into another asset class that has done poorly in order to boost it up and bring it back to the fixed percentage target. If this sounds like buying low and selling high, you are right – that’s the idea.

Of course, as I mentioned above, this strategy has problems all its own. There will be times when all asset classes will do poorly and reallocation will look more like rearranging the deck chairs on the Titanic. It might look nicer, but everyone’s going to get wet and cold eventually. Brrrrr.

Some people are critical of this approach for other reasons. They argue that the last thing you want to do is buy shares of funds that are doing poorly and sell those that are doing well. These arguments are valid, of course. But in my opinion that doesn’t take away from the reality that asset allocation can help reduce investment volatility.

5. Preferred Shares/Dividends

If you buy funds that hold a high percentage of preferred shares or common stocks that pay dividends, you can potentially reduce portfolio fluctuation. Portfolios with these securities have less risk because they have a somewhat more predictable return. Because (at least a portion) of the return is more predictable, there is less risk, which keeps the securities more stable. Also, common stocks that pay dividends tend to have more stable earnings (assuming they are paying dividends from the company’s earnings). Those more predictable earnings drive the volatility of the portfolio down as well.

Of course, since the risk of preferred shares and dividend paying stocks is (generally) lower, the returns are also lower. So any investment that is more stable will conversely grow slower.

Having a portfolio with less volatility can help you stay with your investment strategy longer because hopefully you won’t overreact quite as much. That in turn can lead to greater financial success. The key to finding the right investment strategy for you is to be brutally honest about how much of a roller coaster ride you can tolerate. Once you are clear on that, you can take the steps outlined above to make sure you have a good fit.

What are you doing to reduce investment volatility? What has worked best? What hasn’t worked? Why?

Other Resources

3 Ways to Get More Portfolio Income

How Should I Invest Right Now?

Investment Strategies that Work

Outside Resources

Investing in Volatility – NY Times

Understanding Volatility Measurements