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How to Control Excess Volatility in Your Portfolio

Successful investing is all about balancing the potential for gain with the risk of loss. However the ideal combination for a particular investor can be tricky. Read about what factors to consider to make better decisions when selecting your investment portfolio.

Affluent investors (which are likely readers of this article) probably already understand that diversification can reduce risk. But what if you own 20 different stocks and then a bear market takes them all down? To help cushion your portfolio against that kind of risk you can diversify into different asset classes that may hold up in value when the stock market goes down.

This kind of portfolio diversification is called asset allocation because it involves allocating different percentages of your portfolio into different types of asset classes.

Bonds, cash and real estate are all different types of asset classes that may be expected to offer some protection during a serious bear market.

This is the traditional approach to designing a portfolio mix that will help to control excess volatility; and it involves setting unchanging, fixed allocations in the different asset types (such as 60% in stocks, 30% in bonds and 10% in cash).

Then there is a newer, more active style of portfolio management that involves adjusting the allocations for the different asset types as market conditions change. The active style is generally referred to as dynamic asset allocation or tactical asset allocation.

Traditional Asset Allocation -- Balancing Risk and Reward

How do you design a portfolio mix in the traditional way that will maximize returns yet not expose you to more risk than you can handle? Thats the $64,000 question.

Stocks are the growth engine. So you want as much stock market exposure as you can handle in the form of mutual funds, index funds and diversified groupings of individual stocks. But you have to balance stocks higher growth potential against the risk of a destructive storm because the stock market has historically taken dives of as much as 40%, 50% and even 90% during bear markets.

Since traditional asset allocation techniques are based upon a buy and hold approach, the trick is to decide what percentage of your portfolio should be in stocks so you get some of that growth engine working for you, but not so much that you cant weather a destructive storm if it were to hit.

The right portfolio mix for you will be a reflection of very individual circumstances. The right mix should be consistent with your risk tolerance. If you could not weather a short-term portfolio loss of more than 25%, then you may not want stocks to represent any more than about 50% of your portfolio (if you assume that the next destructive storm wouldnt be worse than a 40% to 50% drop in the market). In that event, a 50% loss in your stock market holdings would translate into a 25% hit to your overall portfolio (assuming the other half is invested in cash or money market funds).

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