Long-Term Strategies for Managing Volatility

When the stock market exhibits more than the usual short-term ups and downs, investors’ thoughts typically turn to managing risk. Although it is usually not desirable to eliminate risk, there are strategies that may help to manage the volatility of your portfolio. A diversified investment mix, a focus on large cap growth stocks, and exposure to active portfolio managers may all help you deal with greater market volatility.

The Return of Diversification

We believe that effective diversification becomes more important in an environment of rising volatility. We expect the interrelationship of stocks and bonds to provide more diversification benefits than in past cycles as real interest rates become the driver of relative performance.

Correlation measures the degree to which asset returns move together or in opposite directions. Over time, the correlation between two asset classes can change. For instance, the relationship between the total returns of stocks and the total returns of bonds has varied over the past 75 years. During much of the 1980s and 1990s, stock and bond prices generally moved together, as reflected in the +0.5 correlation between them over the period.¹ In the 1990s, diversification offered little value to investors — stocks and bonds generally moved in the same direction. In contrast, the correlation between stocks and bonds in recent years — just as in the 1950s — has reversed, reaching -0.5. Diversification is of more value in managing volatility now than at any time in the past 40-50 years!

The recent decline in the stock market was mirrored in a decline in yields (and rise in bond prices) as market participants’ expectations for economic growth were tempered. Indeed, since the peak in the S&P 500 on July 19, the intermediate term government bonds have gained about 5% while stocks have fallen about 5%.²

We expect the correlation between stocks and bonds to remain below the levels seen in the 1980s and 1990s. In an era of a low, stable pace of inflation relative to historical levels, the volatility of interest rates may be driven more by expectations for the real rate of economic growth than by inflation expectations. In general, rising inflation tends to be a negative for both stocks and bonds. In contrast, rising real growth is a plus for stocks but a negative for bonds, because bond yields generally rise and prices fall. A similar period of negative correlation between stock and bond prices resulting from low and stable inflation occurred in the 1950s and 1960s.

A benefit of the changing correlation between stocks and bonds is that as price volatility remains elevated in the years ahead, a lower-than-average correlation between stocks and bonds should produce more benefits from diversification, which should serve to moderate overall portfolio volatility.

Go for Growth

In recent years, it was easy for investors who didn’t periodically rebalance their portfolios to become over-weighted in value stocks — dominated by the financial sector, which is at the hub of the current market turmoil. With the exception of the aftermath of the technology bubble in the early 2000s, value stocks have tended to be more cyclical than growth stocks — meaning they display greater volatility when economic growth slows. As volatility has returned to the financial markets growth stocks have displayed less volatility than their value peers.

We expect better performance by growth stocks in the years ahead. In contrast to the 1990s, the excesses that have built up during the 2000s business cycle can be found in value rather than growth stocks. For example, the energy sector has soared along with energy prices and is vulnerable to a pullback in prices from record highs and the financial sector is exposed to the aftermath of the bubble in subprime debt. The large cap growth asset class is more attractively priced than any time in the last 10 years and earnings growth is likely to remain robust.

Get Active

Active managers benefit in an environment of rising volatility. The percentage of active managers beating their index tends to rise and fall with the trend in market volatility. During the second half of the 1990s economic cycle, volatility steadily rose — as did the percentage of large cap managers beating the market. The percentage of large cap managers beating the index rose steadily along with volatility from 11% at the end of 1995 to 68% by the end of the first quarter of 2001.3 As volatility remains elevated relative to recent years, we may look forward to stronger relative performance by managers relative to their indexes.

While the return of volatility may be unwelcome by some market participants — it may actually be good news. The turna-round in volatility has historically been followed by years of additional gains before the end of the business cycle.

A focus on diversification, large cap growth stocks, and active management can help to effectively manage portfolio volatility. In addition, we believe that rising volatility presents opportunities to potentially enhance return and manage risk through tactical asset allocation shifts. Rather than ignore volatility and adhere to a rigid allocation, we seek to capitalize on market volatility and make full use of the flexibility of our asset allocation framework.

¹ S&P 500 and the Ibbotson Intermediate Term Government bond index
² Ibbotson Intermediate Term Government bond index
³ Chicago Board Options Exchange Volatility Index; large cap core managers in Lipper database.