Volatility chart.
Getty
Volatility is a measure of the degree to which an asset price fluctuates around its average value, and it is an unavoidable reality in the world of investing. Smart investors realize that market sentiment rarely remains stationary for long periods of time and that navigating volatile trading sessions requires an aggressive approach.
Quantifying volatility is a multifaceted endeavor that employs a variety of methodologies, including historical performance indicators such as histograms and the widely adopted Volatility Index, which measures expected 30-day volatility of the U.S. equity market.
Younger investors with longer investment horizons tend to favor more aggressive portfolios that can tolerate volatility. In contrast, investors nearing retirement or who are retired tend to prioritize predictability over volatility and prefer investments with less deviation from the mean.
That being said, while the high returns from risky investments may be attractive, the negative impact of large losses and the difficulty of recovering from a significant drawdown cannot be ignored, regardless of an investor’s age or investment horizon. The effort required to recoup losses is disproportionately large, and the recovery process becomes increasingly difficult as the size of the losses increases.
For example, a 50% loss would require a staggering 100% gain to recover the portfolio’s original value, while a 70% loss would require a staggering 233.33% gain to breakeven. This non-linear recovery trajectory highlights the large opportunity cost associated with large drawdowns, as the time spent recovering losses represents a period of no potential growth.
Let’s say your portfolio experiences a 50% drawdown and takes 5 years to recover. If your portfolio had instead grown at an average annual rate of 7%, it would have increased by approximately 40.26% over the same period. This lost growth represents a large opportunity cost and highlights the importance of minimizing drawdowns to ensure consistent compound returns.
Adopting a low volatility strategy
Stabilizing portfolio performance will lead to greater wealth accumulation in the long term, even if it means temporarily lagging behind during market surges. A low volatility approach minimizes the risk of significant drawdowns and ensures that your portfolio maintains a steady growth trajectory.
By focusing on minimizing portfolio risk, investors can mitigate the impact of external factors such as market downturns, economic recessions, and personal financial difficulties. This approach reduces the likelihood of significant drawdowns and stabilizes the value of a portfolio over time. This is consistent with the adage “slow and steady wins the game.”
Diversification is one of the most effective strategies to reduce portfolio volatility. By spreading investments across different asset classes, sectors and regions, investors can reduce the impact of poor performance in one area. This time-honored principle is similar to the saying “don’t put all your eggs in one basket” and helps protect your portfolio by spreading risk across multiple investment vehicles.
Timing the market is notoriously difficult, especially when it comes to individual securities. A diversified portfolio combines a variety of asset types and investment vehicles to limit excessive exposure to any one sector or commodity. Incorporating both domestic and international holdings can provide further diversification, making a portfolio more resilient to localized market fluctuations.
Diversification is considered essential for a balanced portfolio intended to weather market downturns effectively. If an investor holds only one stock and that stock falls 20%, the value of the portfolio will fall by the same percentage. However, if an investor holds two stocks and one of them falls 20%, the average adjustment of the portfolio will be limited to 10%. Many portfolios hold exchange-traded funds that track indexes made up of hundreds or thousands of stocks, and it is not uncommon for an investor’s portfolio to be diversified across multiple market segments based on thousands of underlying securities.
Dynamic asset allocation adjusts the asset composition of a portfolio in response to changing market conditions. This strategy allows investors to reduce exposure to riskier assets during times of increased market uncertainty and increase exposure during periods of more stability.
Every stock has a measure of volatility called beta, which you can often find in the fundamental analysis section of a stock’s information page. A beta of 1 indicates that the stock will react in tandem with the S&P 500 index. If the S&P 500 falls 0.5%, a stock with a beta of 1 is likely to fall 0.5% as well.
If the beta is less than 1, the stock is considered less volatile than the overall market, while if the beta is greater than 1, the stock is considered to react more violently to market movements. By selling high beta stocks and replacing them with lower beta stocks, investors can effectively reduce the volatility of their overall trading portfolio.
Smart traders often adjust their portfolio volatility in response to market signals, favoring lower beta stocks to increase beta during uptrends and preserve capital during market corrections.
By actively monitoring market signals and economic indicators, investors can proactively rebalance their portfolios and change their allocations across asset classes to better align with current conditions. This approach allows investors to benefit from market upswings while mitigating the impact of downturns, effectively managing risk and volatility throughout the investment cycle.
Adopt a long-term mindset
While dealing with volatility may be essential for short-term traders, long-term investors can often afford to maintain a more steady course. Temporary market fluctuations can be unsettling, but they do not fundamentally alter the long-term goals of a well-constructed portfolio. History has repeatedly proven that markets always recover from downturns, rewarding patient investors who resist the temptation to make impulsive decisions based on short-term market movements.
Investors can weather market fluctuations by adhering to a disciplined investment strategy, diversifying across asset classes and maintaining a long-term perspective. The focus should be on achieving sustainable growth over the long term, rather than reacting to temporary market fluctuations that may ultimately prove insignificant in the grand scheme of long-term wealth accumulation.
Navigating market volatility is an inevitable challenge for long-term investors, but it can be effectively managed by combining a strategic approach with a firm commitment to prudence and patience. By incorporating diversification, dynamic asset allocation, hedging strategies and a deep understanding of individual risk tolerance, investors can mitigate the impact of market fluctuations and position their portfolios for consistent growth over the long term.
While high returns may be attractive, the negative impact of large drawdowns and the difficult road to recovery highlight the importance of prioritizing risk management and minimizing losses. By stabilizing portfolio performance, even at the cost of temporarily lagging during market recoveries, investors can achieve higher final capital and total returns over the long term.
The ultimate goal is not to simply maximize returns, but to maximize wealth through consistent, steady growth. By implementing these strategies and remaining steadfast in the face of volatility, long-term investors can effectively weather market fluctuations and achieve their financial goals with confidence and resilience.
