Managing Volatility
The Financialist • Issue 83 • June 2004
BY ALAN KOTAI
Recent experience has reminded us that investing in the stock markets (either through individual stocks, stock indices, or other equity investments such as mutual funds) can result in significant short-term volatility.
While variations in investment value occur in both directions, we are mostly concerned with downside volatility – the drop in the value of our investments. Since equity investments (investments that represent ownership of such things as stocks, real estate, and direct investments in businesses) have the greatest level of volatility of any asset class, it is this asset class we primarily focus on when we talk about managing volatility.
Illustrating volatility
The following is an illustration of the variability of short-term returns compared to long-term returns in the stock market. In this example, I will use the TSX stock index as a stand-in for the stock market as a whole:
A quick glance at the chart on the left gives you an idea of how volatile the stock market can be from one year to the next. If we look at the chart on the right, however, you can see a much smaller variance of returns. Yet the 10-year graph is comprised of all the points in the 1-year graph. These charts demonstrate the central rule of equity investing: while equities tend to generate the highest long-term investment returns, they also tend to demonstrate the greatest degree of volatility over the short-term.
Why manage volatility?
Knowing this central rule of equity investing, why invest in anything else? Here are a few reasons:
Risk Tolerance
Short-term drops can be very troubling for investors, and can lead to emotionally-based decisions.
Investment Objectives
If you need to make a large purchase using your savings or require a regular income from your investments in the near term, equity investments may not be appropriate considering the short-term downside risk.
Past performance is not indicative of future performance – Looking at historical norms gives us some guidance as to what we can expect in the future, but nobody knows for certain what is going to happen.
How we manage volatility
There are several strategies we employ to manage volatility in your portfolio:
Asset Class Diversification
Diversify among a broad range of securities or investments in the three general asset classes:
Cash
Treasury Bills, high-yield savings accounts, and short-term bonds (very safe but very low returns)
Bonds
Government of Canada bonds, provincial bonds, and corporate bonds (fairly safe with low to medium returns)
Equities
Individual stocks, index funds, and investment funds (volatile but potentially high long -term returns)
Business Sector Diversification
The market is made up of a wide variety of companies – from resource companies to tech firms to banks. By investing in several sectors of the economy at the same time, you reduce the risk of loss should one sector perform poorly.
Management Style Diversification
Portfolio managers tend to have a style or methodology they prefer when managing a stock portfolio. The two key investment management styles are “value” investing and “growth” nvesting. At any given time, one style may outperform another. Using money managers who employ different management styles can reduce the overall volatility of your portfolio.
Dollar Cost Averaging
In an ideal world, you would always buy your investments at the lowest possible price, and sell for the highest possible price. Unfortunately, this is impossible to do consistently over time. However, by investing in equities on a regular basis – say, monthly – you will be buying at various price levels, thereby reducing the risk that you will buy at the “top.” If the price level goes down, you have the opportunity to buy a greater number of units or shares.
While investments and their returns will vary over time, the core strategies we recommend and implement on your behalf stay relatively the same.
If you want to know more about portfolio diversification and how it applies to you, contact your Rogers Group Financial advisor.