Last week I dug into alternatives to low volatility ETFs. In it, I hinted at a another, simpler way to reduce portfolio volatility. It starts with diversification. But it ends with the asset allocation you choose. In other words, you can build a simple portfolio of stock and bond funds that limit the impact of market volatility. In most cases simpler is better. That is the goal here, to show how the simplest allocation strategy can reduce volatility in your portfolio.
Market Volatility
To understand market volatility we need to understand what moves the markets: why stock prices move and the same for bond prices. Most of the causes can be reduced to rumors, news, political, economic, and disasters. Let’s not forget our own behavior plays a role too.
The volume and frequency of these causes drives market volatility. Sometimes it’s slow and sporadic. But too much all at once leaves you with a year like 2011 (one of the most volatile years in the stock market’s history). The Arab Spring, earthquake/tsunami in Japan and Fukushima nuclear disaster, European debt crisis, U.S. debt ceiling debacle, and Occupy Wall Street all contributed to the roller coaster ride that year.
That volatility can wreak havoc on a portfolio. Each drop in the market tests your tolerance too. Nobody likes to lose money. Emotions taint investment decisions, adding to the volatility. Those losses, in turn, need bigger gains to get out of the red. For instance, a 20% investment loss needs a 25% gain just to get back to even.
How Do You Build a Portfolio That Protects From That?
It helps to have something in place before it happens. The goal of asset allocation is to lower risk. That provides a nice effect that smooths out the big drops you’d experience if you were only invested in a single asset like stocks.
To keep things simple, I’ll stick to stocks and bonds. Each asset brings a different type of risk. Stocks are volatile, much more than bonds. History tells us this. Both play a specific role in your portfolio. Stocks bring growth. Bonds provide income and safety.
By building a mix of stocks and bonds you can reduce the risks each asset brings to the table. In turn, it reduces portfolio volatility, limits losses, but still provides the long-term returns needed to accomplish your goals.
Below are examples of four simple portfolio allocations, each using a different mix of a Total Stock Fund and a Total Bond Fund. I used Portfolio Visualizer to backtest each asset mix. In each example:
- Portfolio 1 is a 100% U.S. Total Stock Fund (blue line)
- Portfolio 2 is a 100% Total Bond Fund (red line)
- Portfolio 3 is the corresponding Stock/Bond Mix (yellow line)
Focus on how the big drops in the stock fund compares to each stock/bond mix. It should give you a better idea how a simple allocation strategy will cut down on volatility, risk, and losses.
70/30 Stock/Bond Mix
60/40 Stock/Bond Mix
50/50 Stock/Bond Mix
40/60 Stock/Bond Mix
When you compare all four examples, you can also see how a slight adjustment to each mix affects volatility and performance. It’s similar to cooking where too much of one ingredient can overpower an entire dish. Or, how not enough of another ingredient can underwhelm a dish.
Your portfolio is the same. It only takes an excess of one asset to leave you with a bad taste in your mouth. With your portfolio allocation, you’re looking for the right recipe of assets that fit your goals and ability to handle risk.
The right combination doesn’t end here either. Adding a second or third asset can further reduce risk while boosting performance too. The same can be said for taking valuation into account. We’ll dig into more of this in the future.
Understand, this isn’t meant to show the perfect asset mix for you. Rather, it’s to show how even the simplest of asset allocations, over time, can lower risk by smoothing out volatility in the markets.
