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November, 2012


Volatility is our Friend with Proper Diversification

 

Volatility is often associated with risk. Why then did The Wall Street Journal advise a few days ago that investors need to learn “to love volatility?”1 Lately, large investment firms are publicly stating that investment strategies need to change to take into account increased volatility.2 These recently popular discussions about how to effectively utilize volatility have been a core part of our strategy for over a decade.


Many technical and complicated explanations of “Volatility” exist. But in simple terms, volatility refers to the frequency and intensity of an investment’s price fluctuations. The more frequently the pricing fluctuates, the more volatile the investment is. For example, a security that is up 20% one week and then down 30% the next week represents a very volatile security over these two weeks.


We have always believed that volatility is our friend. If used correctly, volatility can potentially increase your returns. I will explain in a little bit why that is. We’ve also advocated for many years that diversifying across multiple asset classes has a greater potential of taking advantage of volatility. It’s not enough to diversify your portfolio across correlated asset classes. You have to find areas with low correlation. That can be done by investing in public as well as private-exclusive opportunities that are not easily accessible to the general public. Having investments in areas with low correlation to each other can allow you to sell out of strength and buy into opportunities at discounted rates.


Correlation refers to how returns of different securities relate to each other. The more closely changes in valuations of one security match changes in valuations of another security, the more correlated these two securities are. For example, if two securities have identical returns over the same time period, they are perfectly correlated to each other. If you know the return of one of these securities, you can predict the return of the other security for the same timeframe. On the other hand, if the returns of one security give you absolutely no indication of what the returns of another security could have been, these two securities have low to no correlation to each other.


Finding low-correlated investments has become more and more challenging. Massive drops in numerous asset classes in 2008 showed just how correlated investments have become across the world—especially among publicly traded securities. Although you can still find publicly traded securities with low correlation to each other, adding private investments can significantly increase the possibility of low correlation. However, the private market is a complex world with numerous pitfalls if you don’t know what you are looking for. Understanding the risks and conflicts of a private opportunity can be beyond the understanding of even otherwise experienced investment advisors. We don’t recommend you go out and find these exclusive opportunities on your own, but consult a professional with experience in that field.


The following bar graph demonstrates how closely different stock categories are correlated to large cap growth stocks based on data from January 1, 1998 through December 31, 2007. A correlation of 0.5 or higher is typically considered a strong correlation.

Correlation_chart

The vertical axis measures the correlation coefficient on a scale of negative 1 to positive 1. A value of positive 1 indicates perfect correlation (meaning two securities move in lockstep—if one security moves a certain percentage in either direction, the other security moves the same percentage in the same direction every time). A value of negative 1 indicates the securities are perfectly matched, but in a negative manner (when one goes a certain percentage in one direction, the other will move the same percentage but in the opposite direction). The closer the value moves to zero, the less correlated the securities are. A value of 0 indicates there is no relationship between the securities. Whatever direction one security moves has no correlation to the direction and intensity the other security moves.


Why can being diversified across multiple asset classes with low correlation to each other offer benefits especially in volatile times? Because it can lower volatility while offering a chance for higher returns. Most investments go in cycles. They may be doing well during certain times and can be out of favor during others. As long as the manager of the investment has a working strategy and is successful in implementing that strategy, at some point he should experience gains. If he is an inferior manager, on the other hand, waiting for a positive cycle may be a waste of time. So, assuming you are working with good managers, the investments typically experience cycles when the returns are down and cycles when they are up. So if you can buy securities of these managers while they are down and sell them when they are up, you can increase your returns over time. This works especially well if parts of your portfolio are up while others are down. That allows you to carve off money from investments that are up and then deploy the cash to investments that offer opportunities.


The biggest challenge with this strategy for the lay person is that it is counter-intuitive. Emotions tell you not to sell a security that is doing well in order to buy a security that appears to be struggling. And most investors follow their emotions. They buy close to the top of positive cycles and sell close to the bottom of negative cycles. They get caught in what is called psychological entrapment in the investment world.


The following charts demonstrate how the average investor struggles to keep up with the benchmarks.

Average_investor_success

It has been refreshing to see that our strategy is getting picked up by more and more institutional investors. Pioneer Investments, an investment firm managing over $200 billion worldwide, recently explained in a blue paper titled “Living in a More Volatile Investment World” that increased volatility and increased manipulations by central banks have further increased correlation between various markets. These circumstances make “it difficult to achieve meaningful diversification through traditional asset allocation.”2 Around the same time that Pioneer investments’ paper was published, The Wall Street Journal published an article titled “Learning to Love Volatility.”1 The article discusses the need to develop strategies that can benefit from increased volatility. That’s exactly what we have been doing for many years at Cornerstone Wealth Management, LLC.


We believe that proper diversification coupled with volatility has the potential to increase returns while lowering the volatility of the overall portfolio. Proper diversification entails diversifying across numerous asset classes while also diversifying within each asset class across multiple managers in the public as well as private arena. Proper diversification is time consuming and complex, but we believe it is worth the effort.


Sources:

1 Learning to Love Volatility, The Wall Street Journal, November 16, 2012.

2 Michael Temple, Blue Paper, Living in a More Volatile Investment World, Pioneer Investments, November 2012.