While many investors may fall victim to the low volatility that is present in the market, savvy investors know that the stock market rarely stays in the same mood for long periods of time, making it reasonable to believe that volatile trading sessions may soon return. That makes it imperative that traders have a plan for what they'll do when the market, again, becomes tough to navigate.
Key Takeaways
- Volatility is a tool used by investors to determine price fluctuation from a historical mean.
- Broad-based volatility is measured by the Volatility Index, or VIX.
- The most common way to reduce volatility is to diversify a portfolio.
- Some investors will hold cash as it does not track the equities market.
- A combination of ETFs and other index basket securities can help keep volatility low.
What Is Volatility?
Volatility is a measure of the dispersion of returns for a security or market index. More simply put, volatility represents how large an asset's prices swing around the mean price. There are several ways to measure and calculate volatility, with the most simplified and commonly used historical performance indicator called a histogram.
Volatility is something investors are always considering when making investments as volatile assets are generally riskier than assets that experience less deviation from the mean. This concept shapes a significant amount of investor portfolios. It is common to see younger people with more aggressive portfolios that can absorb volatility over a long time frame. It's the opposite for investors nearing or in retirement who eschew volatility in favor of more predictable, less deviating investments.
There is a volatility index called the VIX which was created in order to gauge the expected 30-day volatility of the U.S. stock market. Investors who trade on a more macro approach, investing more in broad ETFs and large indices versus individual securities, will often watch the VIX. A higher VIX means volatility is high, and the market could experience significant price movements. A lower VIX would mean the opposite.
There are some other measures of volatility that may reduce deviation in an investor's portfolio, which are listed below.
Beta
All stocks have a measure of volatility called beta. This metric can often be found in the fundamental analysis section of the stock's information page. A beta of one means that the stock will react in tandem with the S&P 500. If the S&P is down 0.5%, this stock will be down the same amount. If the beta is below one, the stock is less volatile than the overall market and a beta above one indicates that the stock will react more severely.
The best way to reduce the volatility in your trading portfolio is to sell high beta stocks and replace them with lower beta names. You might really like your John Deere stock, but in times of high market volatility, it might wildly fluctuate. Swapping it out with a lower beta stock like Johnson and Johnson would lower the overall volatility of your portfolio.
Traders often adjust the volatility of their portfolio as the overall market sends different signals. When it is going up, they increase the beta. When it is in correction mode, lower beta names help to preserve capital.
Hedging
Hedging involves initiating short positions against your long positions. Let's say that you're holding 100 shares of Qualcomm stock but you believe the market is ripe for a correction. You could short sell 100 shares of a high beta, overvalued stock that would fall at a higher rate than the overall market if a correction occurred. Then, you could cover the short position later when you believe that the market is going to see a recovery. You might have lost money on your Qualcomm position but you made money on the short position.
Bonds
When traders have a high degree of risk appetite, they don't hold a lot of fixed income products, but when the market becomes questionable and they want to find safe havens for their money that won't have severe reactions to overall market moves, they may head for the bond market. Bonds, bond ETFs and treasuries all serve as safe havens when the market is going down. Not only does it reduce volatility, but it still allows the trader to bring in income.
Diversification
Diversification is one of the simplest and most important parts of volatility control. Much like the proverbial "don't keep all your eggs in one basket," diversification helps protect your portfolio by spreading out the risk.
Timing the market is difficult, and even more so with individual securities. In a diversified portfolio, a mix of different asset types and investment vehicles helps to limit being overexposed to any one sector or commodity. These can be further spread out by mixing both domestic and international holdings.
The strategy is considered almost a necessity to a well-balanced portfolio that aims to weather market downturns. If you only own one stock and it falls 20%, your portfolio falls 20%. If you own two stocks and one falls 20%, your portfolio averages out to only a 10% correction. Many portfolios own ETFs that track indices containing hundreds or thousands of stocks, and it is not unusual for an investor's portfolio to be diversified over multiple market segments, built on thousands of underlying securities.
Dividend Investing
Although less popular than broad diversification, dividend investing can be used as an additional safeguard for volatility. When you invest in dividends, portfolio fluctuation decreases as typically dividend-issuing securities pose somewhat more predictable returns. Investors know that the dividend portion is usually paid and there is less risk. This knowledge helps to stabilize the security.
However, since the risk and volatility can be lower, the return can also be lower than more volatile offerings. Over time though, reinvested dividends can purchase additional shares of the same security, reducing risk over a long enough time frame.
Cash
The easiest way to reduce the volatility in your portfolio is to sit out. Selling your positions and going to a higher allocation of cash completely shields you from short-term market fluctuations. Staying in cash for long periods isn't advised, since the money is falling victim to inflation, but for traders who believe the market will soon stabilize, cash is the easy way to mitigate losses.
Responding to volatility may be a necessity for long-term investors. Temporary pops and drops in the market don't change the long-term objective of your portfolio, making it unnecessary to change your holdings. Stay the course and know that history shows that the market always recovers.
How Do you Reduce the Risk of a Portfolio?
You can reduce the risk of a portfolio by diversifying your investments, not buying extremely volatile securities, and holding some cash that is relatively safe from market fluctuations.
What Influences the Volatility of a Portfolio?
The volatility of a portfolio is dependent on the underlying instruments and their price movements. If a portfolio is heavily allocated in a specific market and that market experiences a correction, the volatility will rise substantially. However, if an investor chooses less risky investments and spreads them out, the portfolio should experience fewer periods of volatility.
How Is Portfolio Volatility Calculated?
Volatility is often measured as either the standard deviation or variance between returns from that same security or market index. Calculating volatility is somewhat involved, and a more thorough breakdown of how to calculate volatility can be found here.
What Is Considered High Volatility?
High volatility is a somewhat arbitrary term but is generally applied to a stock that is trading within a 2-3% range of its price. Investors look at a security's historical volatility to determine risk.
The Bottom Line
Reducing volatility in your portfolio can be simple or complex. One of the most popular strategies to reduce volatility is to widely diversify a portfolio while keeping a small percentage in cash. Volatility is measured based on a security's historical price movements and one of the major considerations of investors when placing trades.
