Wednesday, September 12, 2012

Keeping Portfolio Volatility Constant

We are always interested by ways to reduce portfolio risk while potentially increasing returns.  Risk parity is a strategy we have previously written about that can accomplish this, volatility stabilization is another.

Let's say an investor has a simple portfolio that is invested 100% in the S&P 500 at all times.  While the investment is always the same, the risk varies.  Anyone who watches the market understands that there are times when it is riskier than others.  So our mythical investor will have periods where risk is greater than others.  Volatility stabilization seeks to keep risk constant over the entire investing period.  There are a number of ways to apply this, but at its most basic an investor would do the following:

1. Determine current market volatility.  This can be done with a ratio of a past standard deviation to current standard deviation, Bollinger Bands, etc.

2. During times of high volatility positions in the investment(s), in this case the S&P 500 are decreased.

3. During times of low volatility positions in the investment(s) are increased.

4. Leveraged ETFs or mutual funds could also be used to amplify returns during times of low volatility.

Our early testing on this has been positive so far as we are seeing an ability to reduce risk and/or increase returns.

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