First off, if you are a young person saving for retirement my advice is to ignore volatility. If volatility makes you sick to your stomach, don’t check your 401(k) balance.
That said, if you are a retiree or close to retiring, volatility can wreak havoc on your portfolio. Today’s Wall Street Journal had a great article by Eleanor Laise titled Protecting Your Nest Egg in Volatile Times ($). The article stressed three ways that investors can reduce the volatility of their portfolios:
2. Maintaining a big cash reserve
3. Invest in funds that sell call options on fund holdings
My favorite of the three suggestions is the first one, diversification. The article included a fascinating graphic that shows the importance of diversification:
The table shows the returns and standard deviations of various portfolios. If you start at the top, you’ll notice “Large Cap and small cap U.S. stocks.” That means a portfolio 100% invested in large cap and small cap U.S. stocks. Then if you look at the next line, the portfolio includes foreign stocks, so the allocation is now 50% large cap and small cap stocks and 50% foreign stocks. In other words, the portfolios are all equally allocated among the classes.
According to the table, the fully-diversified portfolio would consist of 16.7% of the portfolio invested in each of the classes. This particular portfolio would had an average annual rate of return of 11.3% and a standard deviation (a measure of volatility) of just 8.7%. And to top it off, the portfolio’s worst year would have only been down 10.2%. That’s pretty amazing.
Of course I have to mention the fact that this was a hypothetical study and that not all asset classes were available for investment 37 years ago. Still, I think this is a testament of how important diversification is.