Asset Allocation in the New Environment
Most investors have a distorted view of volatility and risk. It really isn’t their fault; their advisors have been taught to equate the two things and have stated this as a fact. Over a year ago, I wrote about this from the perspective of buying a volatile stock at its lows having only limited risk. The particular example I used there was that buying the volatile stock Micron Technologies (MU) at around $6 represented less risk than buying “safe” US 10 year notes at historically low yields of 1.6%. MU closed yesterday around $17.50 while the US 10 year is yielding around 2.5%, meaning bond prices have fallen dramatically since then, so that seems to have worked out OK.
Of course, this was partly an “equities over bonds” market call, but the point is that risk is at least as much a function of relative price as it is of previous volatility. This doesn’t mean that low volatility in a portfolio isn’t desirable. It can smooth out the ride and help to prevent investors from panicking out of their investments at a bad time. The problem for long term investors, however, is that asset allocation between stocks and bonds wasn’t designed for ultra-low interest rates. In that environment the return on the bonds held is low and the risk of their value decreasing is high. In other words, bonds don’t serve to reduce risk in a portfolio; if anything, they may increase it.
So, what is an investor to do? We have become accustomed to the “low volatility” part of our portfolio providing a return in the form of interest to cushion any price swings. Re-investing the interest also helps to grow the capital base. Many believe that, if you were to forsake bonds, investing in stocks with very low volatility would involve a big sacrifice in terms of performance compared to the general market. They would be wrong.
The S&P 500 Low Volatility Index tracks the 100 least volatile stocks in the S&P 500. The chart below represents the relative performance of that index versus the full S&P. (The original chart and all disclaimers etc. can be found here.)
As you can see, over time, low volatility doesn’t equate to a low return. Of course, past performance does not necessarily point to future performance, but the evidence is pretty strong that some low volatility component in a portfolio could be beneficial.
Investing directly in an index is not possible, but in these days of ETFs, we can come pretty close. It is possible, through Powershares Low Volatility Index Portfolio (SPLV) to replicate the index. It should be said that this fund was established in 2011, so, while it seems to do a good job of tracking the index, there is a limited track record.
The ETF provides an easy, one stop shop option for those wishing to add a low volatility equity component to their holdings, but some may wish to be a little more selective. The Index is weighted so that the least volatile stocks make up a larger percentage of the total, so you could for example, just invest in the top 10 holdings: Johnson & Johnson (JNJ), Dominion Resources (D), Pepsico (PEP), Clorox (CLX), McDonalds (MCD), Sigma Aldrich (SIAL), Marsh & McLennan (MMC), Chubb (CB), Southern Company (SO) and Torchmark (TMK).
If part of the reason for moving from fixed income to low volatility stocks is a fear of inflation and thus high interest rates, however, you may wish to be even more selective. Two of these companies, D and SO, are utilities, and when interest rates rise stock in utilities generally falls. This is because the plant and infrastructure they need necessitates a heavy debt burden, and their profitability is influenced by the cost of servicing that debt.
This would leave an investment in JNJ, PEP, CLX, MCD, SIAL, MMC, CB and TMK. I like to feel in control and believe in the power of “tweaking” so that would probably be my preferred tactic, but for most, simply trusting the past performance of the index overall and buying SPLV will serve the purpose.
I must admit that when I came across the chart above in the course of my research, I was surprised. It seemed counter-intuitive to me that stocks with low volatility would have outperformed the broader market over 23 years. I learned a long time ago, however, that if data challenge assumptions, you should re-think your preconceptions.
We are still learning what constitutes acceptable risk as a 30 year period of ever declining interest rates draws to a close. Successful investors will be those who can forget what they have learned over that period and look again at relevant data. What you find there may surprise you.