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Low Volatility InvestingPosted by securities on: 2006-09-06 09:41:43
By Matthew Tuttle What if we lived in a world where there were only two investments: Bathing suit stocks and umbrella stocks. As an investor you would have three choices: invest all of your money in bathing suit stocks, invest all of your money in umbrella stocks, or invest some in each. If you put all of your money in bathing suit stocks, you would be doing great when it is sunny but you would lose money when it rained. If you put all of your money in umbrella stocks, you would do great when it rained but you would lose money when it was sunny. What would happen if you put half of your money into each? When it rained, your bathing suit stocks would go down but your umbrella stocks would go up. When it was sunny, your umbrella stocks would go down but your bathing suit stocks would go up. You would have reduced the volatility of your portfolio substantially. Your goal would be to make a little money every year with very little risk. Now, let us bring this example into the real world and assume that you can choose to invest in either U.S. stocks or U.S. bonds. A portfolio of 100% stocks would expose you to the risk of a market decline. A portfolio of 100% bonds would expose you to rising interest rates and the possibility of missing a large stock market rally. A portfolio of 50% bonds and 50% stocks would reduce all of these risks, but we can do even better. Now let’s say that you split the portfolio in thirds and add in Real Estate Investment Trusts (REITs). REITs invest in real estate and don’t move in the same direction as stocks and bonds, they exhibit a very low correlation. Instead of traditional bonds we can use bank loan mutual funds, stable value mutual funds, and TIP mutual funds. Unlike bonds, bank loans have a floating rate of interest. Stable value funds have an insurance company guarantee that they cannot go down in value. TIPs are issued by the government and the principal adjusts for inflation. None of these options has the same sensitivity to interest rates that traditional bonds do. We could also add a fund that invests in commodities like oil, precious metals, livestock, etc. These funds do not move in the same direction as stocks or bonds. There is no limit to the types of investments that have a low correlation to stocks and bonds that we can put in. Just like the bathing suit and umbrella example, this type of portfolio should be protected from large swings in the market. In fact, watching the returns of your portfolio should be about as exciting as watching paint dry. Now the question is why would you want to do this? Throughout the late 90’s the investment strategy of choice was trying to beat the market. Then came 2000 to 2002, the market was down about 40% during those years. If you were only down 30% you beat the market, but were you happy? Probably not. Lately, more investors are starting to think about absolute return. Absolute return advocates don’t care what the market does, they just don’t want to lose any money in any given year. They are willing to give up some upside in a year when the market is up 30% in return for not losing much or any money when the market is down 30%. Volatility is also vital for retirees and near retirees. The market decline of 2000 to 2002 was devastating to many who were near retirement or living on fixed incomes. Individual investors can replicate the bathing suit/umbrella example in their own portfolios. Doing so should result in a portfolio that is much less volatile than the stock market. Matthew Tuttle is author of "Financial Secrets of my Wealthy Grandparents". For more information, or to sign up for his free newsletter, please visit http://www.matthewtuttle.com. Article Source: http://EzineArticles.com/?expert=Matthew_Tuttle |
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