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‘);   E-Mail Article   Listen to Article   Printer-Friendly   3-Column Format   Translate   Share Article      Text Size Ken Weeman can remember a time when he and his wife, Kathryn, wrote dozens of personal checks every year to charitable organizations they knew relatively little about. Overwhelmed by the ritual, Weeman, a former Dresdner RCM Capital partner who lives in California, stood back one day and realized that he was “clueless”...

Lessons in dealing with volatility

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The extraordinary volatility gripping the markets culminates a year in which wrenching price swings have become almost commonplace. Stocks, bonds, commodities and currencies have made moves in minutes and hours that in normal trading only occur over the course of days or weeks.
Investors, well off and humble alike, must cope with the turbulence, but those in the first group often pay professionals to do the coping on their behalf. Private bankers, uptown financial planners and others who cater to wealthy clients employ various strategies to help insulate them from, or even profit by, extreme volatility.
The safest approach is to try to sidestep the ups and downs by maintaining especially well-diversified portfolios. Further insulation can come from adjusting holdings to limit exposure to inherently more volatile asset classes, like stocks and commodities, and increase investment in high-quality bonds and cashlike instruments, which normally have smaller fluctuations.
“A very broad-based asset allocation” is the first step in dealing with volatility, said Chris Cordaro, a partner at the financial planning firm RegentAtlantic. He acknowledged, though, that when conditions become acutely difficult, as they have been lately, and volatility spikes, diversification becomes less effective.
“Correlations go to one in a crisis,” he said, meaning that everything goes down together. But they do not stay down for long, he assured: “Coming out of this, diversification is going to work, so there's no reason to abandon it.”
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Rather than trying to parry away the effects of heightened volatility, many advisers tackle it head on in various ways. A safe, straightforward approach, one that is available to investors who have modest portfolios and no outside help, is to rebalance the weightings of various investments.
It is essential when building a portfolio to establish risk parameters and allocate money to different assets accordingly, said Harold Evensky, a financial planner at Evensky & Katz. As markets rise and fall, certain holdings will occupy greater or lesser proportions of the overall portfolio than desired, a process that is exaggerated when volatility rises.
Rebalancing involves adjusting the weightings to bring them back in line with the original plan. An investor who wishes to maintain 55 percent in stocks and 45 percent in bonds, for instance, might sells stocks and buy bonds whenever the ratio goes to 60/40 or do the reverse when it hits 50/50, Evensky said.
That is one way to get the preferred result. Another, said Brett Hammond, chief investment strategist at the fund manager TIAA-CREF, is to do it periodically, say every year or two. “But whatever rule people follow,” he advised, “they should look at their portfolio now because it is likely to look significantly different from how it looked a couple of years ago.”
Another way to manage volatility is to treat it as an asset in itself. There are securities, amounting to cocktails of derivative instruments, that provide higher returns when markets have endured big swings and investors anticipate more of the same.
These structured products, as they are known, are created by investment banks and are not publicly traded. That usually makes them available only to wealthy investors.
Alexandre Zimmermann, head of advisory and investment solutions for SG Hambros, a British boutique private bank, has been increasing his use of structured products since the beginning of the year as a way of “selling volatility.” One vehicle he mentioned pays 10 percent a year for three years as long as the FTSE-100 index of British stocks does not end the three-year period 50 percent below where it started.
If the index does drop that much, investors will be on the hook for the loss, he said, but that would have been the case if they had simply put their money in stocks. Mitigating the loss is the 10 percent they would still pocket for each year that the index did not experience that steep decline.
The protection comes at a price, Zimmermann said; investors are giving up any gain in the index. But he said his clients did not mind.
“They are happy to move from a capital-appreciation strategy to an income strategy while keeping the same underlying risk,” he said.
But it is precisely because the climate is so iffy that Cordaro, the RegentAtlantic planner, would think twice about using these vehicles. They work only if the banks that invent them, and take the other side of the trade, pay up, and that is by no means certain these days.
“With the whole structured-products market, you've got counterparty risk,” he warned. “That was extremely evident” last month.
One way for small investors to avoid counterparty risk and profit from volatility is to sell exchange-traded call options against stock they own. In return for cash, shareholders take on an obligation to sell their stock at a fixed date and price in the future. Volatility is a significant component of an option's price, so this strategy is likely to be more profitable in a climate like today's, all else being equal.