How To Smooth-Out Your Ride In The Stock Market

By Aaron Levitt | September 02, 2014 AAA

Just when you thought it was safe to put away the Dramamine, the stock market has once again started to gyrate in a big way. Volatility is back and investors better get used to it.

Recent events like the emerging market sell-off, lower economic forecasts and Russia’s “invasion” of the Ukraine have once again caused the broad stock market to fall by some big amounts. Meanwhile, some good news is causing just as much euphoria in the other direction. All in all, it’s enough to make you seasick. It’s also enough to seriously impact your bottom line.

For investors, there are ways to manage that volatility and protect a portfolio without directly betting on the VIX-futures funds like iPath S&P 500 VIX ST Futures ETN (NYSE: VXX).

The Roller Coaster Is Here To Stay

At its core, the term volatility refers to the amount of uncertainty or risk of change in a security's value. A high volatility stock bounces around- up or down- more than a low volatility one over a short period of time. While there is nothing inherently wrong with high volatility stocks, these movements can create panic selling and restless nights. Perhaps, more importantly, it can impact the value of your portfolio over the long term.

According to Principal Financial Group, placing $100,000 into two different portfolios- one low volatility, one high volatility- produces two very different outcomes. Assuming they both average 10% annual returns, the low volatility portfolio would be worth $160,905 over five years. The high volatility portfolio would be worth just $154,346. The over $6,500 difference was due to the fact that the high volatility portfolio was forced to deal with lower lows and higher highs. Those price swings impacted that portfolio’s ability to recover after the losses.

What’s scarier still is the length of time required to rebound. If you’re retired and taking distributions from your portfolio, these bouts of volatility could be impossible to recover from. Principal estimates that 40% downturn- like the one we had in 2008- can take nearly 25 years to recover from at a conservative 4% rate.

To that end, low volatility funds could be a godsend to older and retired workers. These funds essentially use screens to kick out high volatility stocks and capture the upside of the market while limiting the downside as well as the “bounciness” associated with markets movements. And with the main volatility Index, also called the Fear Index, reaching new 13-month highs in February, the time to bet on some of these low volatility options could be now.

Smoothing Out The Market’s Ride

By choosing low volatility options, investors can scale back their risk exposure, while still maintaining a position in equities, eliminating the need to run into Treasury bonds or cash. The recent ETF boom has provided a multitude of choices for investors looking to limit their downside risk. The biggest and oldest fund in the sector is the PowerShares S&P 500 Low Volatility ETF (NASDAQ:SPLV).

The $3.6 billion fund tracks the 100 stocks from the bread-n-butter S&P 500 with the lowest realized volatility over the past 12 months. This includes industry stalwarts like Kellogg’s (NYSE: K) and Johnson & Johnson (NYSE: JNJ). Over the last three years, SPLV has managed to produce an almost identical return verses the S&P 500. However, that return has been far less bumpy. Expenses for the fund run a cheap 0.25%.

Another interesting pick could be the SPDR Russell 2000 Low Volatility ETF (NASDAQ: SMLV). This ETF follows the low volatility segment of the small-cap market. By using SMLV, investors can potentially gain all the benefits of owning small-caps (higher returns) while eliminating much of their jumpiness and tendency to sell-off big in the face of danger.

Emerging markets are another huge spot for volatility. As the broad funds like the iShares MSCI Emerging Markets (NYSE: EEM) plunged during 2013’s currency induced sell-off, the various low volatility options in the EM space managed to stem their losses. While EEM finished 2013 with a 3.1% loss, the iShares MSCI Emerging Markets Minimum Volatility (NASDAQ: EEMV) managed to be flat- falling just 0.3% during the year. Likewise, the high yielding EGShares Low Volatility Emerging Markets Dividend ETF (NASDAQ: HILO) could also be another option.

The Bottom Line

Volatility is back. For investors, this nasty problem of gyrating markets can be a real hindrance to a portfolio’s total return. Luckily, there are ways to fight back.

 

Disclosure: The author owns iShares MSCI Emerging Markets Minimum Volatility( NYSE: EEMV). 

 

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