With what seemed like a flip of a switch, when the ball dropped, ringing in 2012, the hyper volatile 2011 investing year was replaced with what has been an early 2012 with very little volatility. The days of up 2% today and down 2% the next day have been replaced with a slow, steady climb to the upside.
While many investors may fall victim to the low volatility that is present in the market, savvy investors know that the stock market rarely stays in the same mood for long periods of time, making it reasonable to believe that volatile trading sessions may soon return. That makes it imperative that traders have a plan for what they'll do when the market, again, becomes tough to navigate.
How can you reduce the volatility in your portfolio? Here are a few ideas.
All stocks have a measure of volatility called beta. This metric can often be found in the fundamental analysis section of the stock's information page. A beta of one means that the stock will react in tandem with the S&P 500. If the S&P is down 0.5%, this stock will be down the same amount. If the beta is below one, the stock is less volatile than the overall market and a beta above one indicates that the stock will react more severely.
The best way to reduce the volatility in your trading portfolio is to sell high beta stocks and replace them with lower beta names. You might really like your John Deere stock, but in times of high market volatility, it might wildly fluctuate. Swapping it out with a lower beta stock like Johnson and Johnson would lower the overall volatility of your portfolio.
Traders often adjust the volatility of their portfolio as the overall market sends different signals. When it is going up, they increase the beta. When it is in correction mode, lower beta names help to preserve capital.
Hedging involves initiating short positions against your long positions. Let's say that you're holding 100 shares of Qualcomm stock but you believe the market is ripe for a correction. You could short sell 100 shares of a high beta, overvalued stock that would fall at a higher rate than the overall market if a correction occurred. Then, you could cover the short position later when you believe that the market is going to see a recovery. You might have lost money on your Qualcomm position but you made money on the short position.
When traders have a high degree of risk appetite, they don't hold a lot of fixed income products, but when the market becomes questionable and they want to find safe havens for their money that won't have severe reactions to overall market moves, they may head for the bond market. Bonds, bond ETFs and treasuries all serve as safe havens when the market is going down. Not only does it reduce volatility, but it still allows the trader to bring in income.
The easiest way to reduce the volatility in your portfolio is to sit out. Selling your positions and going to a higher allocation of cash completely shields you from short-term market fluctuations. Staying in cash for long periods isn't advised, since the money is falling victim to inflation, but for traders who believe the market will soon stabilize, cash is the easy way to mitigate losses.
The Bottom Line
Responding to volatility may be a necessity for long-term investors. Temporary pops and drops in the market don't change the long-term objective of your portfolio, making it unnecessary to change your holdings. Stay the course and know that history shows that the market always recovers.
SEE: Understanding Volatility Measurements