How to Play Defense Against Volatility in Your Portfolio

Time and diversification heal short-term wounds.

August 2011—BOOM!

Watching the markets was like watching a waterfall, and it was not until October 4 that the market hit a low.

Volatility. It drives people nuts.

Actually, let me clarify that: Downside volatility drives people nuts. Not many financial advisers field phone calls from clients asking, “What did you do to protect my portfolio from all this volatility?” when the market is rocketing to the upside. Those calls come when the volatility to the downside rears its ugly head.

Ned Davis Research researched the correlations of each individual stock in the Standard & Poor’s 500 Index in relation to the actual index itself.

Since 1972, the median correlation of an individual stock to the index (measured over the three proceeding months) was 0.46. That means 230 of the 500 stocks in the index (46 percent) moved in the same direction (up or down) as the overall index.

A little over a week ago, that number moved up to 0.86. So for the past three months, roughly 430 of the 500 stocks could be expected to move with the index. That’s almost double the median number. And remember, prior to October 4, the index had been moving down, hard and fast.

High correlation and a lot of volatility … sorry, downside volatility = investor pain. Ouch.

The Prescription

There is a prescription for those investors that are driven nuts by volatility. The problem is that they don’t believe the prescription works.

It’s simply a combination of time and diversification.

Time.

According to a report by JPMorgan Asset Management that looks back over the past 61 years, the best single year for stocks (using the S&P 500 index) produced a return of 51 percent. Conversely, the worst single year for stocks returned a 37 percent loss. That’s a lot of volatility.

However, extend the time period of observation to rolling five-year periods and the return range tightens up to +28 percent and -2 percent. Ten-year rolling periods tighten up even more to +19 percent and -1 percent. Finally, rolling 20-year periods show the range as +18 percent as the best return and +6 percent as the worst return.

Read that again: The worst return over a 20-year rolling period, going back 61 years, was +6 percent.

Diversification.

In addition to time, what about the effects of diversification? It turns out that if you split investments 50/50 between the S&P 500 and the Barclay’s Aggregate Bond Index (a common bond proxy), those one-year and rolling five-, 10-, and 20-year periods look even better than being in all stocks. In fact, the best/worst ranges look like this—one year: +32 percent/-15 percent; rolling five years: +21 percent/+1 percent; rolling 10 years: +17 percent/+2 percent; and rolling 20 years: +14 percent/+5 percent.

In addition to the rolling five-year range being +21 percent/+1 percent, it turns out that the 50/50 portfolio’s average rolling five-year return was +9 percent over the course of the 61 years.

Read that again, too.

Reality.

According to DALBAR, Inc., the average investor had an annual return of 2.6 percent from 1991 through 2010.

Let this sink in. Since the average rolling five-year return for the 50/50 portfolio was +9 percent, that portfolio did three times better over the course of the study than the average investor did between 1991 and 2010 (+9 percent vs. +2.6 percent).

So if you are a long-term investor—someone looking at investment periods of between five and 15 years—does it really matter what has happened over the past 3 months?

What to do.

The next paragraph could possibly be the single most important I’ve written all year.

Find a financial adviser you like and trust. If you have one that you don’t like or don’t trust, fire him and get a new one. Those two things can’t be fixed. Create a financial plan and an asset allocation that is properly diversified and has an appropriate time horizon that accounts for your short- and long-term liquidity needs. After that is done, set it in motion. From there, trust but verify with your adviser to ensure everything is going according to the plan. If it’s not, there is a communication problem, which can easily be fixed by having a discussion and making adjustments.

Why do I think that was the most important paragraph I’ve written all year? Because I’m right. And if I were wrong, there would not be such a huge spread between a 50/50 stock and bond portfolio and the average investor.

Turn off the TV, quit second-guessing, stop the panic behavior, and follow your financial plan.

If you don’t have a plan, get one. After the market has crashed is probably the time when you are most in touch with your REAL tolerance for risk.

If you do have a plan, good, and remember—time and diversification are your best defenses to market volatility and high correlations.

Final point: Unless there was a change in your personal situation or your need for short-term liquidity between August and October, there was no reason to do anything—especially in an investing environment where everything seems to be correlated and volatility is as high as it is.

Why? Because as of this writing, post October 4 returns have already filled most of the hole. Thank you, upside volatility.

David B. Armstrong, CFA, is a managing director and cofounder of Monument Wealth Management, a full-service wealth management firm in Alexandria, Va. Monument Wealth Management is backed by LPL Financial, an independent broker-dealer and Registered Investment Advisor. David has been named one of America’s Top 100 Financial Advisors for two straight years by Registered Rep Magazine (2009 and 2010, based on assets under management) and has been interviewed by severalnational media sources over the past several years. Follow David and Monument Wealth Management on their blog Off The Wall, on Twitter at @MonumentWealth and @DavidBArmstrong, and on theirFacebook page. Securities and financial planning offered through LPL Financial, Member FINRA/SIPC.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance references are historical and are not a guarantee of future results.  All indices are unmanaged and may not be invested into directly.  There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk. Stock investing involves risks including loss of principal. Bonds are subject to market and interest rate risk if sold prior to maturity.  Bond values and yields will decline as interest rates rise, and bonds are subject to availability and change in price. Stocks have traditionally been more volatile than bonds.

Read this article on U.S. News & World Report  >