Just when you thought it was safe to go back into the market, Europe’s sovereign debt problems have reignited the GFC jitters and dragged the global markets back into a state of flux.
Over the past 3 years, the S&P500 Volatility Index (VIX) is averaging levels twice that of the previous two years, and locally the All Ordinaries Price Index has up and downed like a yo-yo and still remains down 28% from its October 2007 peak.
So with volatility the key theme for investors for the foreseeable future, it’s worth revisiting four simple and under-utilised strategies that can help you to reduce the effects of volatility on your portfolio.
1. Laying solid foundations
To volatility-proof your portfolio, it’s crucial that you get the fundamentals right first. Setting a clear goal, investment objective and timeframe, as well as understanding your tolerance for risk, will help establish a suitable investment strategy. Then you can focus on asset allocation.
Asset allocation is more than simply scattering your investment across different asset classes. To allocate effectively and efficiently, you need a reasonable understanding of how different asset classes performed collectively within a portfolio and how to optimise allocations to strike a balance between often competing objectives of:
- generating growth,
- producing income; and
- minimising downside risks.
You have three basic types of asset allocation in your tool-kit:
- Strategic Asset Allocation (SAA) Involves setting long term weightings for each asset class.
- Tactical Asset Allocation (TAA) is a medium-term strategy allowing you to rebalance the portfolio to take advantage of bull market runs or to protect the portfolio from bear market cycles.
- Dynamic Asset Allocation (DAA) is a temporary adjustment, very short term and usefully made to make money, not protect it.
Allocations will also shift automatically as each asset class performs differently under different market conditions. It’s therefore important to set flexible SAA parameters and keep a close eye on your portfolio over time. Being under or overweight in the wrong asset classes can result in higher levels of portfolio volatility, less protection from downside risk, and under-performance.
2. Diversify & Conquer
Diversification is considered to be an effective risk managed tool.
It works on the premise that by spreading your portfolio across different investments within the same asset class, or by investing across multiple asset classes, you can mitigate risk of any single investment under-performing. It also gives you access to more and bigger markets which means a better opportunity for growth and protection.
Diversifying your portfolio
A great way to diversify effectively and efficiently is via managed funds. For example, if you already invest in Australian equities, investing in a global equity fund will diversify your portfolio, and provide you with access to investments not attainable from the domestic market.
Fixed income is a defensive asset and generally has a lower level of risk than equities, so including more defensive assets in your portfolio may help mitigate the downside risk to your portfolio whilst also generating income.
Multi-manager funds can also simplify selecting, blending and managing your allocation to the right managers and strategies. More importantly, they typically invest dynamically across a variety of managers with different styles, strategies and sectors which can help protect the portfolio and outperform the market.
3. To hedge or not to hedge?
If you invest globally, currency hedging should play an important role in mitigating risk from your portfolio. When investing globally, you are susceptible to three variables:
- Value of the foreign asset;
- Fluctuating income; and
- Currency relativity.
Generally, you can’t do much to hedge the performance of the asset and any income it generates, but you can protect the return of the foreign asset from currency fluctuations.
All other things being equal, the higher the AUD, the weaker the foreign currency, the more purchasing power you have in foreign currency terms, but the lesser the value of your foreign asset once converted back into AUD.
Conversely, unhedged investors will generally benefit from a falling AUD as the relative value of the foreign investment increases when converted back into Aussie dollars.
Ultimately, there’s no such thing as the perfect hedge. However, for those keen to try to neutralise currency volatility, consider splitting your global investments across hedged and un-hedged funds.
4. Dollar Cost Averaging
Dollar cost averaging is simple and effective!
It involves making small and regular investments over a long period of time instead of a single investment at a point in time.
Dollar cost averaging works best through volatile cycles where investors buy more units when the price is down and fewer units when the price is up. Longer-term, you generally buy more units at a lower average unit price..
Dollar cost averaging has several key advantages:
- Invest straight away - No need to save up that lump sum investment, invest smaller amounts straight away and avoid trying to pick the bottom of the market.
- Transition cycles - Investors can efficiently transition bull and bear market cycles by making regular investments. This will take the guesswork out of investing, minimise the risk of trying to pick the peaks and troughs as well as reduce unnecessary trading.
- Maximise profits – Investing sooner means improving your chance for maximum long term returns.
- Consistency – Disciplined investing re-enforces an effective and efficient long-term implementation of your investment strategy.
Simple strategies are often the best and generally the cheapest to implement. Taking a long-term approach to investing can also help to avoid over-reaction during volatile times. Of course, the best thing you can do is research so that you make informed decisions.
I’ll be discussing these and more strategies to volatility proof your portfolio in a webinar on Wednesday 11 August 2010 at 12pm. So bring along your questions, I would be happy to answer them.
Happy investing!
