How to Manage Volatility

Most portfolios are nowadays based on the false assumption that the volatility for each asset class remains stable. The reality is investors must actively manage volatility

Gordon Rose, CIIA, CAIA, 12 February, 2014 | 1:59PM
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In part two of our series on risk management strategies, we discussed the risk parity approach in detail and analysed how you can protect your portfolio during volatile markets. In this article, we have a closer look at the target volatility approach - a strategy aiming for constant volatility.

Why You Should Care About Volatility

When asked about their asset allocation, most investors will probably follow a set target (e.g. 60/40), with their portfolios routinely rebalanced to meet it. The problem with this approach is that it implies constant risk for each asset class. As a consequence, most portfolios are nowadays based on the false assumption that the volatility for each asset class remains stable. The reality, though, is very different. In fact, volatility is very volatile in itself. Take the S&P 500 Index; its volatility has averaged 13.9% since 1950, but has ranged between 5.3% and 39.4% along the way. 

Volatility picks up especially during tail events. If investors rebalance their portfolios to its starting allocation when volatility spikes, they would in effect increase the portfolios’ overall risk. Or to put it differently: whenever volatility rises, i.e. the stock market falls, investors would sell the less risky assets and buy the riskier ones.

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About Author

Gordon Rose, CIIA, CAIA,

Gordon Rose, CIIA, CAIA,  is an ETF analyst with Morningstar Europe.

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