Quizmaster, Doug Hutchinson, presents his quiz for the month. Here, Doug explores portfolio volatility.
Consider this Scenario:
Your friend Margaret has recently inherited some money and is considering how to invest it. Her current portfolio is invested exclusively in long term US Government bonds. She is leaning toward investing the inheritance in more long-term US Government bonds, but her friend Tiffany has suggested that Margaret invest this inheritance in a diversified portfolio of stocks instead of buying more bonds. The inheritance will make up 10% of her total portfolio.
Margaret isn’t so sure and she tells Tiffany, “I’m not comfortable with volatility in my portfolio. I want to have as little volatility as possible. So I’m leaning toward just adding more long-term US Government bonds since bonds typically have less volatility than stocks.”
If her goal is to have as little volatility as possible in her portfolio – which investment option for the addition, is most likely to achieve Margaret’s goal:
1) more long-term US Government bonds of the same duration as her existing holidngs or
2) a diversified portfolio of stocks?
Solution:
While it may seem counterintuitive, Margaret should consider adding stocks to her portfolio to reduce portfolio volatility, assuming the stocks she adds have a negative correlation to her current holdings. There are scenarios where adding a more volatile asset to a portfolio can actually reduce the overall volatility of the portfolio as a whole.
More volatile assets can lower the overall portfolio volatility if the new assets tend to move in the opposite direction as the existing assets. This can be measured by correlation, which is a measure of the degree to which returns on two assets move together. If two assets have a negative correlation that means that the assets typically move in opposite directions. Adding a second asset (stocks) to a portfolio of one asset (long term US Government bonds) will reduce the overall volatility of the portfolio if the correlation between the two assets is negative.
Margaret made the mistake of looking at the volatility of the stocks in isolation rather than looking at its impact on the volatility of the portfolio as a whole. Margaret should consider working with a Financial Advisor who can help her build a diversified portfolio that is appropriate for her risk tolerance levels.
The Wealth Managers at WrapManager can help determine if your portfolio is diversified and appropriate for your unique risk tolerance level. Get started by calling 1-800-541-7774 or contact us here to get in touch with an Investor Consultant today.
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