A friend and I were having lunch recently he and suggested that I write an article about volatility and/or non-correlated assets, but then felt that such a topic might be too specific and/or deep. Regardless, I thought that it was a very good idea, and I’ve combined the two topics herein. Hopefully, this will give a better understanding of some of what I do in managing investments, and give some behind-the-scenes insight of my role: to help my clients sleep better at night while still achieving their long-term goals.
Volatility, as described here, means movement of any financial instrument over a specified period. It is directly related to standard deviation, a.k.a. historic volatility. As a refresher, standard deviation is the percent variation from the average and expresses the confidence in any given result; the margin of error is typically between two standard deviations up and down from the expected average 95% of the time. So, if the expected rate of return for Stock A over time is 8% and it’s standard deviation is 6%, then there is a 95% probability that the return will fall between -4% (which is 8% minus (6% x 2)) and +20% (8% plus (6% x 2)) during any given time period.
Note that two different stocks could have the same expected rate of return, but with varying degrees of volatility. Stock B, like Stock A, has an 8% expected rate of return, but Stock B has a 20% standard deviation, so it will have returns between -32% and +48%. So Stock B should also see an average return of 8% over time, but with significantly greater volatility.
I mentioned volatility in a previous commentary, and how a well-diversified portfolio can reduce that volatility. If you invest in equal amounts of Stock A and Stock B, you would still expect to return 8% over time, but the standard deviation is now the average between 6% and 20%, or 13%, which would give returns between -18% and +34% in any given time period. As you can see, this is better than simply holding Stock B as the swings, while still wide, aren’t nearly as stomach-turning.
So, in this example, why not just hold Stock A, which has less volatility, and be happy with your 8% return? Ultimately, there are two reasons: Number 1) you don’t want to put all of your eggs in one basket, and 2) Stock A and B likely don’t move the same way at the same time, particularly if they are in different industries and/or different countries. This is where non-correlated assets come into play. Coming up with a desired rate of return while reducing volatility means finding assets that move in different, ideally opposite, directions. Using the same Stocks from above, let’s assume that they move opposite from one another, so when A is down its maximum amount (-4%), B is up its maximum amount (48%), resulting in a +22% return; when A is +20%, B is now -32%, resulting in a -6% return. So now, due to negative (opposite) correlation, the range of returns is -6% to 22%. Again, the expected rate of return over time is still 8%, but now the standard deviation has been reduced to 7% overall. You now have diversification and have almost the same standard deviation as your least volatile investment. This is very good.
How do you achieve this in the real world? Many ways: diversifying your stock portfolio among industries; diversifying municipal bonds geographically (think of how Texas has fared versus California, Nevada, Florida, Michigan, among others); diversifying globally in both stocks and bonds (see chart); and diversifying into precious metals which move differently from stocks. However, when there a global financial crisis as we experienced in 2008, little of this worked and mostly went down together. So, for some, an answer is to hedge bets through options: instruments that will pay you when your investments go down. This requires a lot of attention, not to mention expenses, and really isn’t for the casual hands-off investor.
Another way is to buy securities that mirror the S&P 500 Volatility Index itself. Why? Historically, nervous investors raise the volatility of the market as a whole, so the premise is that an increase in volatility should parallel a decline in the stock market, and vice versa. This chart shows this mostly negative correlation. So, for some, a small allocation to these types of securities may be appropriate and may make for smoother sailing over time. If you want to know even more about this, please contact me!