How to reduce volatility in your portfolio

Recent sharp falls in shares of some of the world’s largest businesses are a reminder of the volatile nature of stock market investing. Fortunately, there are ways to counter it.

| 8 min read

Experiencing downs as well as ups is a normal, and inevitable, part of investing. Stock market investors should expect a 10% decline in markets more years than not, based on history. Although large declines of 30% or more are less frequent, they are not exactly rare. Since the turn of the century there have been three peak-to-trough declines across major markets – the ‘dotcom’ bust of 2000 to 2003, the 2007 to 2009 financial crisis and the 2020 Covid-19 crash.

Investors in niche areas or in individual shares should expect to encounter even more volatility. Recent moves in some of the world's largest companies are a timely reminder. Facebook shares dropped some 25% as Apple's new privacy settings are expected to cut its advertising revenues by ten billion dollars this year alone.

Earlier stage stocks and companies such as Netflix and Peloton, beneficiaries of the strange lockdown world we found ourselves in during the pandemic, have also struggled recently in the face of higher inflation and likely interest rate rises. Many lockdown darlings have collapsed as investors start to take a more realistic view of their future – and a higher cost of capital to fund growth. Both Peloton and Zoom have fallen more than 70% since their peaks.

Volatility is the 'cost of admission' to the stock market's machine of long term wealth generation, but it can also be destructive. If you lose 50% of your capital you need to generate a return of 100%, i.e. double it, to get back to where you started. Big losses are difficult to recover from, so how can you build resilience into your portfolio to limit volatility and avoid the 'wipe out' scenario?

Fortunately, there are some relatively straightforward measures you can take without impacting long term growth potential too much.

1. Diversify across multiple companies and sectors

Focusing too much on one type of company or one sector will tend to increase volatility across your portfolio. Investors typically build portfolios of various shares and other assets so that they are not overly reliant on any one investment or asset class performing well – this is known as diversification.

As investment great Sir John Templeton put it, “The only investors that don’t need to diversify are those that are right 100% of the time”. Nobody is, so the sensible thing to do is to prepare for different outcomes and spread your money around so you are not reliant on a single company or type of business.

This has been illustrated recently by broader markets being less affected by recent volatility. The US high tech and growth index, the Nasdaq, dropped by as much as 14% in the opening few weeks of the year, but the more diverse S&P 500 lost around 9% over the same period. The Dow Jones index, which contains more companies that represent more ‘traditional’ industries fared much better, falling by 7%, and the UK’s FTSE 100, which is biased towards financials, energy and mining, barely dipped into negative territory.

2. Diversify by geography

It’s also a good idea to spread your portfolio around the world. Holding investments from different geographical areas can further spread risk so you don’t have all your eggs in one basket. However, there can be extra risks such as currency exchange movements when investing overseas. When the pound strengthens it can water down returns from overseas assets but when it is weak it can boost values.

A wide geographic approach can also maximise opportunity. No country has all the best companies so making sure you have some money invested in all the major areas helps to cover all bases. Geographic boundaries mean less these days but having a good global spread can helps ensure your portfolio is diversified. Plus, although different stock markets are often ‘correlated’ with one another (i.e., they tend to move up and down together) they do tend to produce different returns at different times with leadership varying from month to month and year to year.

3. Use funds as well as (or in addition to) shares

Diversification can be time consuming with individual shares. ‘Collective’ investments such as unit trust and Open-Ended Investment Companies (OEIC) funds are designed to do it for you in a convenient way. An equity fund manager typically selects a range, usually 50 to 100, which means less reliance on the performance of any one company. In this way it is possible to own a more diverse portfolio for just a few hundred pounds.

4. Add some other asset classes

Almost all investors can benefit from diversification across various asset classes. History shows that over the long term the stock market is the asset class with the biggest ups and downs but has also provided the best returns – so having the bulk of a portfolio invested here makes sense. However, by blending a variety of investments that are ‘uncorrelated’ (i.e., their price movements are largely independent of one another rather than moving up and down in tandem) it is possible to build a portfolio more resilient to market fluctuations but that can still deliver good performance.

To balance the volatility of equities and help smooth overall returns, investors often add less volatile investments to their portfolio, notably bonds. Typically, bonds pay a fixed amount of income each year (known as a coupon) and repay the original capital at the end of the term. Income varies according to the issuer of the debt. More risky companies have to pay a higher yield to attract investors, while low risk entities (such as many governments) can issue debt with low yields, perhaps in line with general inflation or interest rate expectations, reflecting the minimal risk of default (non-payment of income or capital).

You could also consider investing in more specialist asset classes too – things such as property (for instance through investment trusts in this area), private equity, commodities such as gold and targeted absolute return funds.

5. Avoid fads or at least limit exposure

Investment fads create lots of excitement and often feature sharp price rises that draw increasing numbers of speculators. Once the frenzy reaches a crescendo there is usually a precipitous drop as, ultimately, the price rise isn't justified by reality.

Investing in fads late rather than early can be destructive to your wealth. Although it can sometimes be difficult to discern between a real opportunity and a fad, if you get the sense that an investment is drawing a big crowd it may be best to bow out or at least limit your exposure to a less consequential percentage of your portfolio.

6. Invest regularly

For those that are in the process of building up their investments, regular savings can be an excellent way to counter volatility. By investing monthly in chunks, rather than a larger lump sum in one go, an investor ends up buying more shares or units when prices become cheaper and fewer when they become more expensive. This can be a great way to invest because if you keep buying the market falls you could, over time, turn volatility to your advantage.

This effect is known as 'pound cost averaging', and over longer periods it can help smooth out the highs and lows of the market; though there are still risks and with all investments, you could get back less than you put in.

If you aren’t confident in making investment decisions ‘multi-asset’ funds could be a convenient solution. For instance, Charles Stanley’s Multi Asset Fund range provides diversified portfolios in one easy-to-buy investment, managed and monitored by experts.

Nothing on this website should be construed as personal advice based on your circumstances. No news or research item is a personal recommendation to deal.

How to reduce volatility in your portfolio

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Investment decisions in fund and other collective investments should only be made after reading the Key Investor Information Document or Key Information Document, Supplementary Information Document and Prospectus.

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