If you're afraid of wrecking your car, you stop speeding.
If you're afraid of gaining weight, you stop eating doughnuts.
If you're afraid of volatility, you stop overloading your portfolio with every marginally attractive tech stock you find.
Over the past few months, many investors have learned firsthand what volatility means. One week the
Nasdaq Composite Index
plummets 25%. The next week it gains 10%.
You aren't imagining things.
Market volatility has been moving higher since the mid-1990s. As investors have pushed stock prices to higher and higher multiples of their earnings, changes in these companies' fortunes have resulted in larger and larger swings in their prices. And these days, investors are trading more often and holding their investments for shorter periods of time -- another contributing factor.
If you can't stand the recent swings in your portfolio, you can reduce these fluctuations by turning to that basic tenet of investing: diversification.
"Do you have a lot of the same stuff in your portfolio?" asks Pat Burke, principal in investment policy and analysis at
. "If everything in your portfolio has gone in the same direction, then you aren't diversified."
Simply, you want to have your money in securities or asset classes that will not move in lock-step with one another. For example, airline and oil stocks are both volatile, but they tend to move in opposite directions. When energy prices are high, airlines tend to suffer because a big component of their cost structure is fuel, but the oil names will do well. When energy prices are low, the reverse will happen.
To temper your high-growth tech stocks, consider adding some bonds, international stocks or long-ignored value names to your portfolio.
Bonds might sound boring, but they typically have a very low correlation to stocks, meaning the two asset classes do not move in tandem.
And they are less risky. Theoretically, you get paid more for taking on more risk. Since bonds provide less return, they carry less volatility.
Bonds do have risks tied to default, interest rates and inflation, but they do have known cash flows. You know upfront how much money a bond will pay you in interest from now until maturity, plus you know you'll get back the bond's face value.
Equities also have default, interest-rate and inflation risks, but on top of that you don't know what that stock will make for you over a given period of time, whether from dividends or a rise in price, and you aren't assured of getting any of your money back.
"You would expect -- on average -- more volatility in stock portfolios," says Andrew Lo, a professor at the
MIT Sloan School of Management
and director of the
Laboratory for Financial Engineering
By adding bonds or cash to your portfolio, you will lower its return but significantly reduce its fluctuations.
For the five years ending April 30, a portfolio with 60% of its assets in the
and 40% in the
Lehman Brothers Aggregate Bond
index would have produced an annualized return of 17.8%, compared with a 25.3% return for the S&P alone, according to data from
T. Rowe Price
. Yes, your returns would have been about 30% lower with the bonds (over an unusually strong period for the S&P 500 index), but they would have come with 40% less volatility than the all-stock portfolio.
Cash or Treasury bills will also help preserve your stock returns.
found in a recent study that if you had half your money in Treasury bills (a cash-like investment) and half in the S&P 500 index over the past 40 years, you would have retained 76% of the market's returns with only half the volatility.
Realistically, you probably wouldn't want more than 20% of your money in bonds or cash, assuming that you aren't retiring in a few years.
recommends a 5% cash allocation for its most aggressive clients. For the most conservative investor, the firm suggests keeping 25% in cash.
If you don't want to sell existing securities and possibly generate capital gains, you can simply start directing new money in a bond or cash investment. You can find a money-market fund at any mutual-fund company or bank. For exceptional no-load bond funds, you can inspect offerings from
. In addition,
PIMCO Total Return is a well-known intermediate-term bond fund. This fund has delivered an average annualized return of 5.6% over the past three years, which ranks it above 92% of its peers, according to
. (It comes with a 4.5% front-end sales charge, though.)
Now is the time to stop ignoring those vocal proponents of international investing.
Investing a portion of your money overseas will indeed cut some of the volatility out of your portfolio.
From 1960 to 1998, if you had 100% of your money in the S&P 500, your return would have been an annualized 12%, according to data from Vanguard. But if, over the same period, you have put 30% of your portfolio in
Morgan Stanley Capital International's Europe, Australasia and Far East
(EAFE) index, your annualized returns would have been about the same 12%, but the portfolio's volatility would have been 13% lower.
Ned Notzon, who oversees T. Rowe Price's asset-allocation
funds, typically keeps 20% to 25% of assets in international stocks, but now that allocation is up to 30%.
"Domestic has been so strong that, in most of our asset-allocation portfolios, we have an overweighting in foreign equities because of the attractive prices," says Notzon.
You can find a variety of international index funds at Vanguard. The
T. Rowe Price International Stock fund is another large, well-recognized fund, or check out some lesser-known funds, like
Artisan International or
Gutting the Growth
Even if you have international funds in your portfolio, you could still have too much of your money in growth stocks.
Growth and value do move in definite cycles when growth beats value and vice versa.
During the last six years, growth has been the dominant style. But that will change sooner or later. "In 1994, academic research said growth was dead," says Vanguard's Burke.
Obviously, that didn't happen.
If you want to stop battling the volatility in your portfolio, you may want to put half your money in growth and half in value. "It would be much more tolerable," Burke says.
How do you know whether a fund's style is growth or value? Don't trust the name. Instead, inspect its holdings. See whether it holds traditional value sectors, such as bank stocks, or check Morningstar's style boxes.
More Sectors, More Small Cap
You can further diversify your money by making sure you aren't concentrated in large-cap stocks or in any one sector.
index, which represents the entire U.S. market, is a good proxy for what your portfolio should look like.
Approximately 25% of the
Wilshire is in small- and mid-cap stocks, while the remainder is in large-cap. Technology only represents 33% of the index. If most of your money is in technology, try increasing your weighting to other dominant but less aggressive sectors, such as basic materials or even utilities. The
Select Sector Spiders
, exchange-traded portfolios that track specific sectors of the S&P 500, give you an easy way to increase your weighting in a particular area of the market.
Sticking With Stocks
If your stock portfolio is out of balance, but you're willing to hold on to it over the long run, time is a great antidote to volatility. Over 10 years or more, the ride will look a lot smoother than it will over one- or two-year periods.
If you can stand the churning, you may not need to do a thing.
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Dear Dagen aims to provide general fund information. Under no circumstances does the information in this column represent a recommendation to buy or sell funds or other securities.