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Diversify to defend against volatility
The stock market of today is more volatile than in previous decades. This is due to the heavier influence in today’s market of institutions like hedge funds and high frequency trading. Also the high degree of global economic and geopolitical instability of today’s world can feed the “fear” emotion among investors which leads to increased market volatility.
The question comes up a lot in dealing with clients as to how volatility can be reduced in their investment portfolios. Diversification among asset classes and individual securities holdings in a portfolio is one important way in which portfolio volatility can be reduced. Asset class diversification represents the allocation in the portfolio to major asset classes such as stocks, bonds, real estate, and commodities. These asset classes have a low degree of correlation to each other (correlation being the degree to which the classes move in tandem with each other under various market conditions). Combining asset classes with low correlation in a portfolio can reduce the overall volatility of a portfolio.
In terms of securities holdings, portfolio volatility can be reduced through a) increasing the number of individual securities held (up to a point); b) holding higher quality and dividend-paying securities; c) diversifying the industry or sector exposure of both stock and bond holdings. Income-producing securities tend to have lower volatility generally. Industries and sectors also have widely varying correlations to each other, so expanding industry exposure improves the “diversification” of the portfolio and thereby helps to reduce overall volatility.
Studies have shown that lower volatility portfolios tend to outperform higher volatility portfolios over long periods of time. In these turbulent and volatile markets, structuring a portfolio so that it is adequately diversified both by asset class and securities holdings can create a greater source of value to the investor through a) reduced volatility, b) increased income, and c) opportunity for capital appreciation.
Islander Bob Toomey is Vice President, Research for S.R. Schill & Associates, a registered investment advisor located on Mercer Island.