You can reduce volatility by focusing on what you can control. I will show you portfolio risk control strategies to manage volatility that is reducing portfolio returns. Limiting portfolio volatility should be part of every investors risk management plan.
Why You Must Control Portfolio Volatility
In a previous post we established portfolio volatility lowers portfolio returns. I demonstrated how 3 portfolios with the identical arithmetic average returns (i.e. 5%) can provide different portfolio total returns, depending on their volatility. The more volatile portfolios underperform the less volatile portfolios.
You must comprehend this concept to understand why you need to control portfolio volatility or suffer the consequences. Two portfolios, with the same average rate of return over a period of years, can produce dramatically different values outcomes because of portfolio volatility. This makes portfolio risk control a vital part of investment management.
Focus On What You Can Control
Volatility has and always will be a part of the stock market. There is nothing you can do about the market. Therefore, you need to focus on what you can control.
You can focus on valuation and price. You can focus on your investment plan and your portfolio asset allocation. You can focus on rebalancing your portfolio and keeping your emotions in check. You can focus on portfolio risk control strategies.
Portfolio Risk Control Strategies
Establish a Maximum Portfolio Drawdown Plan
A maximum drawdown plan is the first step in planning to avoid losing a large chunk of your portfolio. Bear markets can destroy portfolios for years to come. Many investors just give up and avoid equites after their portfolio is decimated.
If you have a maximum drawdown plan it may cause you to invest more conservatively. Hopefully, it will cause you to take only risks that are prudent and fit into your long term plan.
Rebalance Your Portfolio – Frequently
Individual stocks and ETFs that have risen in price may be a larger percent of your portfolio than you desire. In addition, they may be over valued. The reverse may be true of investments that have fallen in price. They may be a smaller percent of your portfolio than you desire and there is a good chance they are a better bargain at the lower price. The solution is portfolio rebalancing.
Implement a Tactical Asset Allocation
We know from history (see Shiller PE 10) that when valuations are high the expected rate of return is lower than average. But when valuations are low the expected rate of return is much higher than average.
This means valuation should be a major consideration in your asset allocation. A tactical asset allocation should be used for portfolio risk control. It does not make sense to have a fixed asset allocation with no regard for the valuation of the asset.
When the valuation of an asset is high, lower your asset allocation to that asset. When valuations are low, increase your asset allocation to that asset.
Increase Portfolio Returns By Being More Conservative
If you focus on what you can control these portfolio risk control strategies can greatly decrease the volatility of your portfolio. Decreasing volatility, all things being equal, will increase your portfolio returns. Yes, being more conservative can increase your portfolio returns.
Related Reading: Perceived Risk vs. Real Risk: A Key to Successful Value Investing