High-yielding, high-volatility portfolios may be the topic of conversation at cocktail parties, but it's the boring, low-volatility portfolio that will maximize an investor's wealth over the long run.
Let's look at two portfolios. Portfolio A has a lot of high-volatility investments and has returned -20%, +25%, and +10% over the past three years, an average return of 5% (-20 plus 25 plus 10, divided by 3). However, because of the wild swings in the return of this portfolio, it has a standard deviation (measure of volatility and risk -- the higher, the more volatile) of 23%. An investor who invested $100,000 three years ago would have seen this portfolio grow to $110,000. The total return for the three years was 10%.
Portfolio B has less-volatile investments and a more stable annual return: -10%, +15%, and +10% over the same period, an average return of 5% (-10 plus 15 plus 10, divided by 3). However, because the returns for Portfolio B are in a tighter group, it has a much lower standard deviation of 13%. Because of this, an investor who invested $100,000 three years ago would have seen this portfolio grow to $113,850. Total return for the three years was almost 14% -- and it ended up with $3,850 more than Portfolio A!
How so? Let's look at the math:
Portfolio A
Start: $100,000
Return Gain/Loss Portfolio Value
Year 1: -20% -20,000 (100,000 times 80%) $80,000
Year 2: +25% +20,000 (80,000 times 125%) $100,000
Year 3: +10% +10,000 (100,000 times 110%) $110,000
Portfolio B
Start: $100,000
Return Gain/Loss Portfolio Value
Year 1: -10% -10,000 (100,000 times 90%) $90,000
Year 2: +15% +13,500 (90,000 times 115%) $103,500
Year 3: +10% +10,350 (103,500 times 110%) $113,850
The impact is even more pronounced if an investor is taking withdrawals from the portfolio. Assume the same investors are retired and have to withdraw $4,000 per year from their portfolios to meet living expenses. Portfolio B would be worth $4,290 more than Portfolio A ($100,390 vs. $96,100).
How can you reduce the volatility in your portfolio?
- Buy mutual funds instead of individual securities. Mutual funds or exchange-traded funds will immediately diversify your holdings, reducing your portfolio risk and volatility.
- Add non-correlating assets to your portfolio. That is, add investments that don't move in the same direction all the time. Asset classes that are positively correlated tend to move in the same direction, and negatively correlated assets will move in opposite directions. Adding bonds can help. Most investment-grade bonds and stocks have historically had little correlation. For example, the Vanguard Total Bond Market ETF (NYSE: BND) and its mutual-fund counterpart have collectively had a negative correlation to the SPDR S&P 500 ETF (NYSE: SPY) for the past 10 years, according to Morningstar data. However, not all bonds behave this way. High-yield junk bonds tend to move in the same direction as stocks. For example, for the past 10 years, the T. Rowe Price High-Yield Fund (PRHYX) has moved in the same direction as the S&P 500 about 77% of the time.
- Sector funds are better than owning individual securities; however, you'll gain even more diversification and lower volatility by investing in a more diversified ETF. At 16.3%, the SPDR S&P 500 ETF has a much lower standard deviation than the SPDR Select Technology ETF (NYSE: XLK), whose volatile components give the fund a standard deviation of 27.4%. Energy, industrial, and consumer discretionary sector funds have also experienced greater volatility than the S&P 500 over the past decade.
Low volatility by itself is no way to build a portfolio. If that were the most important factor, then everyone would own Treasury bills, earning less than 1%. However, an investor can and should take steps to reduce portfolio volatility and improve long-term performance through better diversification. Remember, lower volatility is good and especially critical for retirees or others who are drawing down their portfolios. Boring results may not be a good cocktail party topic, but conversation doesn't pay the bills. A bigger portfolio does.
