Using Diversification to Control Volatility

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Asset Allocation
Using Diversification to Control Volatility
by Roger Wohlner (Write for us!)
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The past few years have taught investors the meaning of volatility in investing. While investors weren't that concerned about volatility before 2000, when it worked to their advantage, the negative volatility of the past few years has been much tougher to deal with.

It has pointed out the necessity to look beyond average rates of return to the volatility of those returns. Even if your projections for the average rate of return are correct, the pattern of those returns will affect your ending balance. It is the compounded annual rate of return over your investment period that will determine your portfolio's ultimate balance, not the average rate of return. For instance, consider the performance of the Standard & Poor's 500 (S&P 500) for the period from 1997 to 2003. Annual returns were 33.4% in 1997, 28.6% in 1998, 21.0% in 1999, -9.1% in 2000, -11.9% in 2001, -22.1% in 2002, and 28.7% in 2003, for an average annual return of 9.8%. However, during the same period, the compounded annual rate of return was 7.6%, 2.2% lower than the average return.*

Periods of loss, especially toward the end of your investment period, can seriously erode value. Subsequent gains then have to first restore the lost value before principal begins to grow again. For instance, to overcome a 25% decline in an investment, you need a gain of 35%. While you want to find ways to control volatility in your portfolio, you probably don't want to totally eliminate it, since volatility is typically rewarded with higher returns. Your objective should be to remove uncompensated risk from your portfolio and then find an acceptable level of risk and return.

Some points to consider when diversifying your portfolio include:

Make sure to hold a broadly diversified portfolio of stocks.
A recent study of stocks from 1960 to 2001 found that diversifiable risk has increased substantially over that period. Thus, it will generally take a portfolio with a larger number of stocks to achieve adequate diversification. This study found that holding 25 stocks reduces diversifiable risk by 80%, 100 stocks reduces diversifiable risk by 90%, and 400 stocks reduces diversifiable risk by 95% (Source: AAII Journal, July 2004). These reductions are compared to the risk of holding a single stock.
Hold both stocks and bonds in your portfolio.
Stocks tend to have a low positive correlation with corporate and government bonds, meaning on average, movements in stock prices will only moderately impact movements in bond prices. For instance, in 2002, the S&P 500 had a return of -22.1%, while long-term government bonds returned 17.8% and intermediate-term government bonds returned 12.9%.* Thus, owning both stocks and bonds reduces your portfolio's overall volatility.
Evaluate new investments carefully.
Make sure they add diversification benefits to your portfolio before purchasing them. You don't want to keep adding similar investments, such as several stocks in the same industry. Not only does that not add much in the way of diversification, but it makes your portfolio more difficult to monitor.
Rebalance your portfolio annually.
Since your asset allocation strategy is designed to provide a stable risk exposure, your portfolio must be periodically rebalanced so the allocation does not get out of line. Your portfolio may become more risky if one asset class starts to dominate your portfolio.
Call for an evaluation of your portfolio.
The importance of a properly diversified portfolio has become apparent during the past few years. Yet, it has also become apparent that it is now more difficult to ensure your portfolio is properly diversified.

* Source: Stocks, Bonds, Bills, and Inflation 2004 Yearbook, Ibbotson Associates. The S&P 500 is an unmanaged index generally considered representative of the U.S. stock market. Investors cannot invest directly in an index. Past performance is not a guarantee of future results. Returns are presented for illustrative purposes only and are not intended to project the performance of a specific investment.