We would all love it if stock prices only moved in one direction, gaining value over time, but the reality is that volatility is part and parcel of global markets, especially when investing in riskier assets like equities.
Volatility refers to the degree and frequency of price changes in individual stocks, an index like the S&P 500 (VOO-NASQ), or the market as a whole over a given period.
This volatility reflects the constant re-evaluation of asset prices based on new information, economic shifts, company performance, and investor psychology.
While it often evokes thoughts of market downturns or corrections, volatility simply refers to the magnitude of price changes in relation to its average, regardless of direction, with higher volatility typically resulting in larger, more unpredictable price changes.
Macroeconomic factors
Stocks can experience volatility due to various factors, from what is going on in the world from a political perspective, such as trade wars, conflicts, and elections, to macroeconomic trends like inflation and economic growth.
The cyclical nature of markets can also deliver variable sector-specific returns at different times in that cycle and in response to shifting macroeconomic factors. These factors typically affect entire markets or sectors, dragging down or lifting all related stocks.
Company-specific factors
Company-specific factors like earnings, revenue growth, emerging competition, new product or service innovations, mergers and acquisitions, or legal, regulatory or reputational issues have a greater influence on individual stocks.
Company-specific factors are crucial drivers of a stock’s volatility because they directly impact investor perception of a company’s financial health, future prospects, and overall risk.
Ultimately, anything that alters the market’s perception of a company’s current and future earnings, its competitive position, or its overall risk profile can contribute to its volatility.
Reducing Portfolio Volatility
The most common way to reduce portfolio volatility and lower investment risk is to diversify across industries, sectors, geographies, themes and asset classes.
Diversification can help to limit overall portfolio losses when one market, sector or asset class performs poorly.
When this happens, the other investments in your portfolio can help offset some of the losses and balance your average return profile, effectively smoothing out the volatility.
Creating a diversified portfolio also offers exposure to a broader set of opportunities, which creates more balance and less volatility in a portfolio.
Chasing Uncorrelated Returns
Portfolio diversification can take different forms, but the key is to include a range of investments, with some that offer uncorrelated returns to the largest portion of your holdings.
Reducing correlation means investing in different asset classes and regions that typically move independently in response to market conditions, ideally in the opposite directions or not to the same degree as the core portfolio holdings.
The core idea of diversification is to reduce risk without necessarily sacrificing returns. Including uncorrelated (or even negatively correlated) assets in a portfolio smooths out overall volatility without eroding the overall return profile when market factors change.
Constructing a Diversified Portfolio
When investing in stocks, DIY investors can take different approaches. For example, they could balance consumer staples with growth stocks.
Consumer staples typically weather downturns in an economic cycle as demand increases for necessities like food, beverages, and household products.
In contrast, growth stocks tend to struggle in tough economic conditions but offer better returns in periods of economic growth.
Investors can also invest in stocks across a range of industries, with a good balance of growth and value stocks to ensure that poor performance in one sector doesn’t overly impact the portfolio.
For example, investors can gain exposure to growth stocks by investing in the technology sector with stock picks like Apple (AAPL-NASQ), Microsoft (MSFT-NASQ) and Nvidia (NVDA-NASQ), and e-commerce players like Amazon (AMZN-NASQ).
They can also add value stocks for less volatility and sustained growth with consumer staples like Procter & Gamble (PG-NASQ), retailers like Walmart (WMT-NASQ), or healthcare stocks like Johnson & Johnson (JNJ-NASQ) or Pfizer (PFE-NASQ).
Geographical diversification can help to reduce volatility in specific countries or regions due to economic, political, and currency risks. For example, investors can balance exposure to trusted developed markets like the US and Europe with exposure to emerging markets in the Asia-Pacific region or Africa, which offer higher growth potential.
Thematic investing allows investors to target long-term structural trends that are less correlated to traditional markets, like green energy, artificial intelligence (AI), or innovations in healthcare like genomics or weight-loss drugs.
Some investors will also diversify across assets, holding cash in local and foreign currencies, as it does not track the equity market.
Making Diversification Easier
Including exchange-traded funds (ETFs) in a portfolio is an efficient and cost-effective way to diversify by gaining broad exposure to local and global stocks.
The baked-in diversification in ETFs spreads risk, which can mitigate some of the company-specific and broader economic factors that can cause volatility in single stocks.
Investors can also easily invest across sectors, like technology, healthcare, financials or energy, styles like growth and value, or gain exposure to themes to express their investment flair or align with their values and views.
In addition, ETFs offer opportunities to diversify investments across asset classes, with ETFs available that provide exposure to bonds, commodities, cryptocurrencies, and others.
Ultimately, a diversified portfolio is more resilient to market volatility, providing smoother returns over time with less risk. This strategy can also align with different investment goals, like balancing growth with capital preservation.
