Wednesday, May 13, 2015

Targeting Portfolio Volatility

Volatility is an important factor in designing portfolios for clients.  First off, volatility tends to be negatively correlated with returns, meaning when volatility of an asset increases returns tend to decrease.  Second, volatility can hamper the "investor experience".  We have talked about the idea of optimizing investor experience in the past.  It basically means that at the end of some horizon the investor has earned as much as reasonably possibly while being able to tolerate the ride.  When volatility is high the ride is bumpy and becomes much less tolerable.

In traditional portfolio construction volatility is assumed to be static, today's volatility is tomorrow's volatility.  So an investor might construct a 60/40 stock/bond portfolio, using the bonds to dampen volatility.  That same investor might be willing to assume more volatility than a 60/40 portfolio would deliver in a stable environment but not willing to assume the level of volatility the same portfolio would have during a volatile environment, so the 60/40 represents a compromise.  This compromise causes the investor to not make as much as they could during a low volatility period and causes the investor to experience more volatility than they are comfortable with during a highly volatile period.  This eventually leads to a poor investor experience.

Targeting portfolio volatility is a much better approach.  For example, in the same 60/40 portfolio the stocks would be more volatile than the bonds.  Assume you want to target an annualized level of volatility, for example 12%.  During times when stocks are not volatile the percentage of stocks would increase vs. bonds.  During times when stocks are volatile their allocation would decrease vs. bonds.  Instead of a static portfolio the investor would have more in stocks during low volatility environments, setting them up for more potential returns, and would have less in stocks during high volatility environments, lessening the bumpiness of the ride and perhaps avoiding major drawdown.