Monday, March 12, 2007

Taking advantage of volatility

If you are in the market, or watch the markets, you'll know that the past few weeks have been more volatile than we've come to expect over the last few years. This leads many to believe that the volatility is unusual. In fact, the opposite is true...the tranquility over the last few years, historically, is more unusual than the recent volatility.

Most investors do not like volatility, since, by traditional measures, it increases risks. And, if you get whipsawed by trying to react to each up and down, or worse, begin listening to the experts about which way the market may be headed next, it will hurt your financial performance.

Handled properly, though, volatility can be your friend. In fact, my system for managing my investments depends on it to outperform the averages. If you've read my previous posts, you'll know that I advocate a fixed allocation, broad diversification and dollar cost averaging. If you follow the advice in those posts, you'll have gone some distance toward taking advantage of volatility.

However, this system depends to a large extent on the idea that various stocks, various industries, various markets are uncorrelated. While there is some truth to this, the fact is that there is a significant amount of correlation between all these areas, particularly in the short term. After studying the amount of volatility which is typical and observing the correlation that is also typical, I concluded that a twist on my philosophy could enhance my returns, which I believe has contributed to my outperforming the markets.

Here is the way it works. After I set up my allocation, I assume that each asset will perform in line with the historical average for investments. Then, when I make my regular adjustments, instead of the classic rebalancing, I buy or sell each asset up to the assumed value. To make this possible, I start with a significant amount of cash (above my emergency fund) in a money market account. With this approach, I keep my target allocation (except for the cash, which becomes the reservoir for this process), but can take advantage of volatility even when there is a significant amount of correlation between the assets. Of course, I use a spreadsheet to make these adjustments and because of this, the whole adjustment process takes about 15 minutes per month. Essentially, this process puts dollar cost averaging on steroids. Of course, the cash can be a drag on performance in times of low volatility, but in times of higher volatility it more than makes up for it in increased dollar cost averaging benefits. Either way it decreases the volatility of your overall portfolio.

As I mentioned, this has worked for me, but I'd certainly be interested in any comments on this approach.

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