Volatility – Why diversification matters and how to reduce risk in your stock portfolio

By diversifying your assets you can balance risk and reward in your investment portfolio

Market Volatility
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Any investment portfolio will be subject to a certain amount of volatility over time. A portfolio’s exposure to volatility can and needs to be managed to prevent permanent loss of capital, or temporary impairment. In this article we discuss volatility and risk and how diversification can be used to reduce a portfolio’s volatility. We also look at other strategies that can be used to lower a portfolio risk.

Volatility vs. risk

Risk / Reward Ratio
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When it comes to investing, risk and return go hand in hand. Investors are rewarded for taking on risk, but that risk sometimes results in losses – both permanent and temporary. Volatility is commonly used as a proxy for risk, although strictly speaking it is just one type of risk investors face.

Besides volatility, investors face counterparty risk, liquidity risk, credit risk, inflation risk, horizon risk and longevity risk. Many of these risks can be mitigated by doing thorough research and through diversification. Volatility is the single biggest form of risk and needs to be thought of in terms of an individual security and an entire portfolio. Investment portfolios are particularly susceptible to volatility caused by market risk as many assets are correlated. For this reason, there is more to diversification than simply spreading a portfolio across several investments.

What is volatility?

Volatility Explained
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In statistical terms, volatility refers to the dispersion of the returns of an asset. In plain English, it refers to the amount an asset’s price or value moves up and down. The volatility of a security can and does change over time, but changes over time are usually gradual. Since the actual future volatility of an asset cannot be predicted, historical volatility is used as an indication of likely future volatility.

Portfolio managers and financial advisors use historical volatility when constructing investment strategies to optimise the expected return and risk of a portfolio. Not only is volatility a feature of most asset prices, but it can also be a good thing and offer investors opportunities. Some of the best investing strategies use volatility to buy undervalued assets and sell overvalued assets. 

How to measure volatility and risk of a portfolio?

Measure Volatility & Risk
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The most common measure of risk is standard deviation, though variance, which is the squared deviation can also be used. Volatility can be calculated using daily, weekly or monthly returns or price data. For an accurate measure of the volatility of returns, daily returns over at least a 90-day period should be used. To calculate the volatility of a single instruments returns, the returns are first summed, and the result is divided by the number of periods, resulting in the mean return. Next, the difference between each value should be calculated, and squared.

This results in a series of squared deviations from the mean. The variance is obtained by summing the squared deviations, and then dividing by the number of periods. The standard deviation is the square root of the variance. A portfolio’s volatility is calculated by calculating the standard deviation of the entire portfolio’s returns. If you compare this to the weighted average of the standard deviations of each security in the portfolio, you will find it is probably substantially lower. The total return and risk of a portfolio can be compared using the Sharpe ratio and Sortino ratio.

The Sharpe ratio compares the portfolio’s return versus a risk-free asset’s return with the standard deviation of returns. A Sharpe ratio of 1 or more indicates a satisfactory return to risk trade-off, while a ratio below 1 indicates a lot of risk is being tolerated to generate the return. The Sharpe ratio is calculated with the following formula:

(Return of portfolio – risk free return) / standard deviation of returns

(Note: the standard deviation should be calculated on excess returns.) The Sortino ratio is a similar measure, but only includes downside volatility – i.e. negative returns. The idea is that positive volatility is good and should not be included in a measure of risk.

What is correlation?

Correlation
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You may have noticed that whenever the S&P 500 index falls more than 2 percent in a single trading session, almost every other stock market in the world opens lower the following day. This is because stock markets are correlated.

When asset prices are correlated it means they move together to some extent. The correlation coefficient of two assets can be statistically calculated and always falls between –1 and +1. A correlation of 1 means two assets are perfectly correlated and will move exactly the same amount each day. A correlation of -1 means two assets are perfectly negatively correlated; if one rises 1%, the other will fall -1%. Correlations between -0.3 and 0.3 means there is very little correlation between returns.

While all stock markets are correlated to some extent, stocks within any one industry or sector are even more correlated. There are several reasons for this. Companies in the same sector are exposed to the same economic and market forces, and because they compete, they apply pricing pressure to one another. Investors also tend to expect their performance to be similar which reinforces the correlation.

Beta is a similar measure which indicates the extent to which a stock moves in relation to a stock market. A stock with a beta of 1 will on average rise and fall the same amount as the overall market. A stock with a lower beta moves less than the market, and a stock with a higher beta moves more than the market.

Examples of highly volatile instruments and investments

Highly Volatile Instruments
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Some trading instruments are more prone to volatility than others. This depends on several factors including the economic forces they are exposed to, the maturity and profitability of a business and how liquid they are. Speculative stocks are the stocks of companies with no earnings or track record and are likely to show higher volatility. Their stock prices are based on unproven prospects for the future and sentiment can easily change.

A company that is subject to rumours and speculation of corporate action or potential bankruptcy is also likely to have a highly volatile stock price. A stock with low liquidity will almost always show higher volatility as anyone buying or selling the stock may move the price in either direction. Other volatile stocks include those with very high PE ratios, high debt levels, or unpredictable earnings.

Commodity prices also have high historical volatility due to the way supply and demand can be influenced by weather, geo-political issues, interest rates and economic growth. The smaller a commodity market is, the more volatile the price will be. The price chart of nearly any cryptocurrency is likely to show very high volatility. This is because the crypto market is primarily driven by speculators. Because the intrinsic value of a crypto asset is difficult to calculate, a selloff won’t be countered by value investors buying.

Any leveraged product, or market with a high number of leveraged positions, is likely to be volatile. Traders use leverage to increase their returns but are often not in a position to ride large price swings. This can make them forced buyers or sellers, adding to overall volatility.

Why diversification matters

Asset Allocation / Diversification
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Most equity-like instruments generate positive returns over time, but also exhibit volatility. Avoiding that volatility by attempting to time the market is easier said than done, and usually results in lower returns. A better approach is portfolio diversification which allows the volatility of any one asset to be tolerated.

By spreading a portfolio across a number of asset classes, the entire portfolio won’t be subject to the volatility of any one asset class. The less correlated the investments in a portfolio are, the lower the volatility will be. Some assets are negatively correlated which can reduce portfolio volatility even more. For example, gold is seen as a safe haven, which means the gold price often appreciates when riskier assets like emerging market bonds see their prices fall.

One of the primary responsibilities of wealth managers is making asset allocation decisions to optimize long term returns while minimizing risk. To generate higher returns, a portfolio needs to have exposure to some risky assets. But assets with higher expected returns come with higher volatility. Diversification allows the higher volatility of riskier assets to be offset by including uncorrelated instruments. Over the long term a diversified asset portfolio will have lower overall volatility, yet each asset class will still generate its own optimal return.

How to reduce volatility in a portfolio?

Reduce Volatility
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There are several ways to reduce portfolio risk using diversification as well as other methods:

  • Diversification within an asset class: Volatility of each asset class within a portfolio can be reduced by adding instruments that have a low correlation with one another. Concentration risk is a commonly overlooked type of portfolio risk. It occurs when securities in a portfolio are highly correlated or exposed to the same economic and market forces. Within an equity portfolio, stocks from different industries, sectors and countries should reduce the overall volatility. Stocks can also be diversified by market cap, stage of maturity and growth rate.
  • Diversification across asset classes: While diversification within an asset class will reduce volatility, it can only do so to a certain extent. Research has proven that the benefits of diversifying a stock portfolio do not meaningfully improve beyond 25 stocks. Adding different asset classes can further reduce the overall volatility of a portfolio. Besides bonds and cash, alternative assets, including real estate, hedge funds, commodities, private equity and venture capital funds can be added to a portfolio. These asset classes all have unique factors driving them, leading to a return profile very different from one another or equities.
  • Diversification by investment style: Different investment styles tend to perform well at different times. Using a mix of investment styles, including momentum, value and mean reversion within each asset class can also smooth the returns over time.
  • Hedging using short positions: Using short positions in overvalued securities can also reduce volatility. Ideally securities that are likely to fall more during bear markets than they rise during bull markets will offset losses during a market correction or crash.
  • Hedging using options and volatility: Buying put options or volatility will also provide downside protection. It’s important to be aware that buying downside protection does come with a cost and will usually result in slightly lower performance.

The best instruments and strategies to reduce volatility

The following instruments and strategies can all be used to reduce overall portfolio volatility.

Alternative assets

Commodities
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  • Real estate, private equity and venture capital can all be used to generate long term returns. These asset classes are all illiquid which is generally viewed as a disadvantage. However, this also means prices usually are not as volatile as in liquid markets.
  • Commodities have very long cycles, and sometimes offer protection against inflation and the devaluation of financial assets. While most tradeable instruments are financial assets, real estate and commodities are tangible assets. This makes these two asset classes more resilient to inflation and periods of uncertainty.
  • Precious metals like gold and silver are also real assets that can act as a hedge against inflation. They also act as a safe haven asset which means their prices can actually appreciate when financial assets lose value rapidly.
  • Hedge funds follow a wide variety of strategies, many of them uncorrelated with other markets. Market neutral hedge funds in particular use strategies that remove beta and can therefore be used to reduce market risk in a larger portfolio.
Data Intelligence Fund
Data Intelligence Fund managed by Catana Capital

Some modern quantitative investing strategies are specifically designed to generate uncorrelated returns. Catana Capital’s Data Intelligence Fund, for example makes use of big data, artificial intelligence and market sentiment to generate returns with less volatility and low correlation to overall equity indices. Using original and unique products based on empirical data increases the chances of returns being both positive and uncorrelated.

Option strategies

Put options can provide downside protection, provided the options are based on an index that is correlated with the portfolio being hedged. Buying put options on their own can be expensive, but an option structure like a short fence or put spread can reduce the cost of buying downside protection.

Volatility instruments

VIX Index
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Implied volatility is a component of option pricing formulas and reflects the expected volatility priced into any option. You can also buy volatility itself, in the form of futures contracts or ETFs with long exposure to a volatility index. The most widely followed of these is the CBOE VIX Index, which is an index of implied volatilities on S&P 500 options.

Conclusion

Volatility and risk are one of the realities of investing. They cannot be avoided entirely, but investors can reduce the impact on their portfolios. Diversification and hedging are the most effective ways to reduce most types of risks and volatility. The more a portfolio is diversified across different asset classes and strategies, the more volatility can be reduced.

About Richard Bowman
Richard Bowman is a writer at Catana Capital, analyst and investor based in Cape Town, South Africa. He has over 18 years’ experience in asset management, stockbroking, financial media and systematic trading. Richard combines fundamental, quantitative and technical analysis with a dash of common sense.

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