Doughnuts, Diversity, and Market Volatility

Market risk can be managed but not eliminated entirely, by holding investments in several different investment categories, or asset classes.

Comfort food until it becomes detrimental to your 'financial' health

Comfort food until it becomes detrimental to your 'financial' health

In the midst of both an election year and more tension in the Middle East, it can be tempting to avoid making any investment decisions at all these days, given the heightened levels of market volatility and uncertainty. Interestingly, a plate full of doughnuts can teach us a lot about investment strategy in stressful times. Although a diet of sugar and carbs may seem comforting at the moment, it will eventually upset our systems, keep us awake at night, and lead to undesirable outcomes. So too, can an investment diet that is out of balance with our long term objectives.

As investors, we are exposed to financial risk, or volatility, in two general ways: company-specific risk and market risk. Long-term investors can reduce exposure to company-specific risk by diversifying among many different stocks within the same asset class.  Market risk can be managed, but not eliminated entirely, by holding investments in several different investment categories, or asset classes. It’s the familiar theme of not keeping all our eggs in one basket.

Correlation is the Key

Longer term, the market risk associated with an individual asset class, such as stocks, may be reduced by allocating a portion of a portfolio’s assets to other types of investments that historically have reacted differently to market and economic events.  A statistic known as correlation measures the tendency of two investments to move together. A correlation close to zero indicates that two investments are largely independent of each other. The closer a correlation is to 1.00, the greater the tendency two investments have had to move in tandem.
Below are four assets that have had relatively low correlations with U.S. stocks during the past decade (Sources: S&P Capital IQ Financial Communications; Barclays Capital). Remember, past performance does not guarantee future results; there is no guarantee that a diversified portfolio will enhance overall returns or outperform a nondiversified portfolio, and diversification does not ensure against all market risk. However, having an imperfect strategy is generally preferable to having no strategy at all.
• Commodities  (0.33)
• Cash  (-0.07)
• Investment Grade Bonds  (-0.06)
• Home Prices  (0.14)

Managing Single-Security Risk

Modern portfolio theory is founded on the assumption that investment markets do not reward investors for taking on risks that could otherwise be eliminated though diversification. A 2003 study found that at least 50 stocks may be required in one’s equity portfolio to provide sufficient diversification.

Fortunately, there are many strategies available for diversifying a stock portfolio. Investors can allocate portions of a portfolio to domestic and international stocks, which may take turns outperforming depending on circumstances in various global economies. An allocation to small-cap, midcap, and large-cap stocks also provides exposure to companies of various sizes. Although there are no guarantees, smaller companies may be nimble enough to exploit untapped market niches and capitalize on growth potential.

Dividend Strategies

In addition, equity investors looking to reduce volatility may want to consider dividend-paying stocks. Although a company can potentially eliminate or reduce dividends at any time, a dividend may provide something in the way of a return even when stock prices are flat or declining. When evaluating dividend-paying stocks, it may be worthwhile to review how long a company has paid a dividend and whether the dividend has increased over time. According to a study by Standard & Poor’s, firms that had increased their dividends for the past 25 years outperformed the S&P 500 and also were less volatile during the 5-year, 10-year, and 15-year periods ending December 31, 2011. (Past performance does not guarantee future results!)  When investing in dividend-paying stocks, be aware that tax rates on qualified dividends are scheduled to increase in 2013 unless Congress acts to avoid the impending fiscal cliff and changes the tax laws.

When the markets get jumpy and investors seek shelter from high volatility, the temptation is strong to pull out everything and run to cash, even though interest rates are at or near zero. Furthermore, trying to successfully time re-entry into the markets without missing a quick upward recovery can be practically impossible.  For the long-term investor, asset allocation with low-correlation investments, diversification, and dividend-paying stocks are all noteworthy methods worthy of consideration in an uncertain world.

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