Contributors to Volatility
Let's quickly highlight some common types of risk that contribute to volatility and discuss different ways you can address each risk type in your portfolio.
Market risk comes with exposure to a particular asset class or sector, such as U.S. equities or emerging markets bonds. This type of risk is the threat that the entire market segment will lose value. For example, U.S. stocks might slump if investors think that the U.S. stock market has climbed too high given slowing economic growth. Alternatively, emerging markets bonds may slump in value because investors expect that inflation will jump up, prompting interest rates to rise. (Rising interest rates tend to be bad news for bonds.)
To help limit market risk, you can diversify into various markets and sectors that will behave differently under different economic scenarios. By doing so, you're reducing your portfolio's dependence on a single market segment.
For example, high-quality U.S. bonds generally perform well when investors are feeling fearful about the health of the economy, so they're a good counterbalance to stocks. In a similar vein, high-yielding securities (such as utilities stocks and real-estate investment trusts) generally perform poorly when interest rates rise; you can balance those investments with low- or no-yielding choices.
Operating risk and price risk are two company-specific factors contributing to short-term volatility of individual stocks.
Operating risk is the risk to the company as a business and includes anything that might adversely affect the firm's profitability.
Price risk, meanwhile, has more to do with the company's stock than with its business: How expensive is the stock in light of the company's earnings, cash flow, or sales?
To limit company-specific risk, you may invest in a collection of stocks, rather than just a few individually. Owning mutual funds or exchange-traded funds, which are diversified baskets of investments, is one way to help mitigate company-specific risks.
Whether you invest only in U.S. stocks or put some dollars outside the U.S. market, they are exposing their portfolios to the risks of investing in that country. There's political risk, or the risk that the current leadership will change for the worse, as well as the threat that economic conditions in that country could make it hard for companies to grow.
And if you're investing in securities denominated in a currency other than their home currency, as is the case when investing in most foreign-stock mutual funds, there's a chance that the foreign currency could lose strength versus your home country's currency. Then there's the risk that the currency will lose its strength versus other currencies.
To limit country risk, you can do one of two things. If you own both U.S. and foreign securities, you can invest in a variety of markets, not just a few. If you invest strictly in U.S. securities, you may want to ensure that your investments aren't overly reliant on just the U.S. for your success--for example, by making sure some of your portfolio's companies have expanded internationally, even though they're headquartered in the U.S. In that case, those companies will probably be more resilient than less-diverse companies when the U.S. economy slows.
So what's the bottom line for managing all these different types of risk that you face? The main way to help reduce day-to-day and week-to-week volatility is to diversify your portfolio across different types of securities. By combining varying investment types in your portfolio, you can help reduce the impact of any one risk factor and therefore help limit short-term volatility.
Read Next: How Much Volatility Can You Take?
Keep in mind that while diversification may help spread risk it does not assure a profit or protect against loss in a down market.
Investors should consider the investment objectives, risk, charges and expenses of mutual funds carefully before investing. Mutual funds are subject to market fluctuation including the potential for loss principal. A prospectus contains this and other information about the fund and may be ordered through www.scottrade.com or through a Scottrade branch office. The prospectus should be read carefully before investing.
The analytical tools described in this article are for information purposes only and their use does not guarantee a profit. None of the information provided should be considered a recommendation or solicitation to invest in, or liquidate, a particular security or type of security. Investors should fully research any security before making an investment decision.