How to Reduce Volatility in Your Portfolio
How does a good portfolio manager reduce volatility?
For us, it starts with looking at your asset allocation. Asset allocation is the amount of volatility that you can sustain or stand over a period of time. If you’re not able to stomach a 40% loss, you’re not going have 100% equities. Equities as an asset class have historically outperformed, but also have had more volatility. There is no free lunch.
If you want equities, you’re going to get the free volatility as well. If you don’t want the volatility, sometimes they’ll go towards a fixed income. A balanced strategy would be one that would have less volatility, maybe 60% equities, 40% fixed income, but also have less returns. That’s the first step, taking a look at asset allocation.
Next, we take a look at the portion of your portfolio that has equities. Can we find stocks that have either a lower beta relative to the stock market and stronger cashflow?
If we focus on companies that fall 8% when the market falls 10%, well that’s dramatically less volatility. If there is proven consistent cashflow and proven consistent dividends, typically those companies will have less volatility. If you own those in your portfolio and there is a crash, usually those maintain their value a little bit more. Focusing on companies that have lower beta with higher expected return or higher expected cashflow, that’s one thing too.
We want to find an asset class that either doesn’t move or is uncorrelated to the market. That might be something like a private debt. Maybe it’s a private equity, maybe it’s a limited partnership or a private real estate investment. Those will have way less volatility or even no volatility. If we can find an asset class that produces income, dividends, or yield with a little bit of growth, that’s an easy way to avoid volatility regardless of what happens in the market.
Assets with Zero Volatility
Third, we will look at assets that have zero volatility whatsoever and are evaluated quarterly or semi-annually or even annually. These pay income, yet are stable; have downside protection, but don’t move; this will do wonders for a portfolio and its volatility. If you have an asset and the shares stay at $10 for the entire year and you get a crash, that’s a very good feeling, knowing that your $10 is still $10.
We also want to take a look at asset classes that have some principal protection built in. You can do that through something called a structured note or a principal protected note. These are equity like components or equity like investments that have one portion of the assets buying either protection for a crash. The assets are usually principle protected, or at least the first 40% of the assets are protected.
This does wonders for downside protection in a crash because the assets are fully principal protected. A concrete example of that would be a principal protected note tied to an underlying index. The underlying index could be the TSX or bank stocks, but the underlying note is fully principal protected. If there is a crash, the assets are guaranteed. You still get the exposure to the market, but you actually get the principal protection on the assets.
Looking at assets that are uncorrelated, taking a look at principal protected assets, at assets that have lower beta and taking a look at alternative assets are all things that we do to take a look at volatility. For us, volatility and risk reduction are not something we only consider when we think a market crash is coming. We do this on a day to day basis with all our portfolios all the time, whether or not we’re hitting new highs or we’re hitting rock bottoms in the market.
It is important to factor in volatility what you’re able to stomach, and this has to be done in conjunction with a plan. It has to be done in conjunction with a cash flow projection for your needs, for your retirement and what it looks like for you.
You’re the one who needs to sleep at night. You’re the one who needs that cashflow. You’re the one who has a desire to retire, or maybe you’re already retired. We have to build that portfolio for you based on your needs. That’s where it starts.
It truly is a custom-built portfolio for you based on asset allocation needs and tolerance.