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Investment Volatility vs. Portfolio Volatility

Yesterday I wrote about the advantages of dollar-cost-averaging into a volatile investment as opposed to DCA’ing into a non-volatile investment. (Short version: When DCA’ing into an investment, greater volatility allows for greater returns because, when you’re DCA’ing, you’re automatically taking advantage of market low points by buying more shares. The lower those low points are, the better.)

What I didn’t really stress yesterday is that the necessary volatility is investment-level volatility, not portfolio-level volatility. What’s that mean?

It means that, theoretically, you could create a portfolio of investments that are each volatile, but with opposite timing as to their respective ups and downs. By doing so, you would be taking advantage of the added returns from DCA’ing into volatile investments, while at the same time smoothing out the fluctuations of your entire portfolio’s value. Pretty neat, huh?

How easy is it to do?

Unfortunately, not very. In previous decades, such a result could be achieved by investing part of your portfolio in U.S. equities, and part of it in international equities. However, over the last 20 years or so, as our respective countries’ economies have become increasingly indistinguishable from each other, so have the returns of our countries’ stocks. (Evidence: The precipitous decline of our stock market over the last few months has been closely mirrored by declines of equity markets across the developed world.)

An alternative option that some (too many?) people suggest is to use fixed income investments along with equity investments in order to smooth overall portfolio return. The problem here, however, is that fixed income investments–while they do often move opposite to equity investments–actually provide a lower return over extended periods of time. In my opinion, when you’re still in your investing years, it’s just not worth it to sacrifice returns in order to reduce the volatility of your portfolio.

Worth the effort?

The way I see it, looking for investments whose volatility is oppositely-correlated in order to smooth out portfolio volatility is a nice idea, but unlikely to be worth the effort. And chasing after a goal like low portfolio volatility can lead you to make decisions that don’t make sense in terms of overall portfolio return (overinvesting in bonds, for instance). Besides, if you’re still in your accumulating-investments years, portfolio volatility isn’t really a problem, is it?

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  1. Another problem is for obvious psychological reasons, people typically come to asset allocation at exactly the wrong time. We’re reading a lot about it now (I don’t mean here, I mean in general in the blogosphere/media) because it’s clear if you were 50% in bonds/cash or whatever, you’d be well up versus someone 100% in stocks, given the market falls.

    But if you’re going to suddenly embrace diversity in your portfolio you should do it when the high return class has enjoyed several years of growth, not when it’s depressed. i.e. 2000 or 2007.

    (And then maintain your asset allocation going forward, and try not to be too clever, of course! 🙂 )

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