Make sure your investment portfolio is maximally diversified before volatility hits and then do not react when it does hit.
A volatile stock market
A volatile stock market is characterized by a prolonged period of large daily stock price changes. In periods of high volatility stock prices can decline significantly.
Stock market volatility, as measured by the VIX index, shot up in December 2018 and January 2019 and stock prices tumbled. Volatility subsequently receded, but emerged once again, albeit to a lesser extent, in August of 2019. These occurrences are a reminder that volatility can hit stocks at any time and we should be prepared for it.
It is worth noting that sometimes high volatility and the associated decline of stock prices are not caused by economic fundamentals but instead by investor psychology.
Making an investment portfolio robust to stock market volatility
1. Diversify your portfolio, now
What is it? Diversification is the most powerful risk management tool in all of investing.
How is it implemented? By investing in all major asset classes around the world. There are many major asset classes around the globe. Examples include U.S. Government bonds, stocks of developed markets such as Germany, U.K. and France, bonds from developing economies such as Brazil, China and India and U.S. commercial and residential real estate.
In principle, diversification means holding a large number of securities within each asset class. For the U.S. stocks asset class it would mean holding the shares of about 4000 companies. For the U.S. Government bonds asset class, it would mean holding about 2000 government bonds. In practice, fortunately, diversification can be accomplished by investing in a single investment fund within each asset class. Consequently, instead of investing in many thousand of individual securities, one can hold a fully diversified portfolio by holding 10 to 20 funds.
What does it achieve? It reduces the risk of a portfolio without reducing the portfolio’s long-term investment return.
An illustration of diversification: Say you had a portfolio invested in U.S. stocks and bonds which grew at an average of 8% per year. You could increase its diversification by adding an international component, such as the stocks of companies in developed European economies. This, in turn, would decrease the risk of your portfolio without decreasing its average rate of return. The intuition is that European stocks tend to behave differently than U.S. stocks. An event like the Federal Reserve raising interest rates has a different effect on U.S. stocks than on European stocks. And as long as U.S. stocks and European stocks do not move in lockstep with one another, they will offset each other’s risk without offsetting each other’s rates of return.
In fact, if you carried on diversifying your portfolio until you reached maximal, or full, diversification, you would have a portfolio with the minimum possible risk for your 8% average rate of return. You would thus have a portfolio which would enjoy the maximum protection against stock price downturns while maintaining its 8% average return.
This remarkable property of diversification is often referred to as the only free lunch in finance and its discovery was awarded the Nobel Prize in Economics.
How does this help me in volatile stock markets? By fully diversifying your portfolio, you will minimize its exposure to stock price declines while maintaining its average, or long-term, rate of return.
Ideally, each investment account in a household (including IRA, 401K, SEP and Individual accounts) should be diversified. And to avoid excessive exposure to an employer, participation in company stock programs should generally be minimized.
2. Don’t react—making changes to a portfolio during a volatile stock market is counterproductive
Many investors sell all or part of their stock holdings during stock market volatility and later repurchase stocks when stock prices are rising. However, evidence strongly indicates the strategy of not making any changes to a portfolio during volatile periods significantly outperforms the strategy of selling stocks during a stock market downturn and buying them back during a market upswing. So whether or not volatility is justified by economic fundamentals, the correct response to it is to not respond at all.
Putting it all together
1. Diversification is the most powerful risk management tool. A fully diversified portfolio enjoys the maximum robustness to stock market volatility.
2. Not making changes to a portfolio results in a significantly better outcome than trying to time market volatility by selling stocks during volatile periods and buying back stocks when volatility recedes.
To sum up, the best way for your portfolio to weather the storm of a volatile stock market is for it to be fully diversified before the storm hits and to not make any changes to it during the storm.
Dr. Andy Lawson is the principal of Freshfield Investments, a Registered Investment Advisory firm in Plano, Texas serving clients locally and nationwide. Freshfield provides investment management and financial planning as a fee-only, fiduciary. To book a virtual or in-person complimentary consultation, please visit our Contact page.
 VIX is an expectation of the volatility of the S&P 500 imputed from put option and call option data from the S&P 500. A high VIX level indicates a high expected volatility in the S&P 500 over the next 30 days.
 Barber and Odean (1999, 2000, 2001) and Odean (1998, 1999)