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Ideas for a less volatile portfolio

2022.4.4 Vítor Ribeiro, CFA

Volatility is not risk.


Do you agree with this sentence?

Volatility is undoubtedly one of the main factors associated with decision making within an investment portfolio. We feel the variations in the value of the portfolio, mainly the negative variations, in a very intense and uncomfortable way. Therefore, the question we want to see answered is: how to get a portfolio with less volatility?

Leaving money on demand, investing in term or structured deposits, savings or treasury certificates, capitalization insurance, are some of the examples most associated with controlling volatility and investors with low risk tolerance. However, this seeming guarantee of stability comes at an ever-increasing cost. With the recent and expected levels of inflation and the interest rates associated with this type of investment it means that we are, in effect, investing to lose money.

Faced with this scenario, many investors and savers have decided to turn to alternatives, which are not always suitable for investors with low risk tolerance, but are often seen as having low volatility. Among them is the purchase of direct real estate. The rationale, there it is, remains the same: “hold” (emotionally) the capital invested and obtain a return that, in this case, is expected to be higher than traditional investments.

This analysis is not intended to be a source of arguments to invest in one or another asset, but rather an alert for the way we make investment decisions, taking into account the volatility of assets. The truth is that we prefer undiversified investment in a property (most investors are not able to acquire a property portfolio that allows them to diversify risk) than diversified, efficient and cheap investment in a global equity ETF.


So why do we have this preference?

The lack of daily listing of a property, for example, may be one of the reasons. For the investor, who exchanged money sitting in the bank for a property and even used leverage (bank financing) for part of the acquisition (I remind you that this is an investor with low risk tolerance), the money is there in that physical/real asset whose market value is often confused with the amount invested, waiting for its appreciation and even obtaining income via lease. In financial assets, we no longer think like that. Buying a stock ETF that replicates the MSCI World Index, which means investing in around 1500 companies in the developed world, we know their market value at all times, which can be much higher or lower than the amount invested (there is visible volatility ), in which companies it is invested, in which regions, what is the ESG rating and with the possibility of obtaining practically immediate liquidity, depending on the time at which we make the decision. In this case, we don't have patience, we don't look to the future and the reasons that led us to invest.

Investing in real estate or a global portfolio of shares are, of course, different investments. They can be complementary and play important roles in an investment portfolio, but given the volatility scenario, it seems that we prefer to dispense with transparency in relation to their market value.

The truth is that if both were purchased for the long term, the impact of day-to-day variations shouldn't be a concern. But we know it is. This article is about volatility, not about one investment alternative being better than another. Volatility is information and is on our side to remind us of risk tolerance.

The solution must not be to avoid knowing its current value. On the contrary. It makes sense to have full access to that information, in either case. But this information should not be the trigger for making the decision to invest or divest.

There's nothing wrong with preferring to invest in real goods rather than financial assets. We just have to be aware of the importance of information and the benefits and constraints of both for the scenario we defined at the beginning: an alternative with low volatility to traditional financial investments for investors with low risk tolerance.


The importance of asset allocation

Correct asset allocation means having a diversified portfolio across different asset classes that allows us to go through different economic cycles and invest taking into account our plan, that is, aligned with objectives, risk tolerance, preferences and restrictions.

If the portfolio is well diversified, we will also have the answer for inflation:

  • allocation to shares, in different sectors or regions
  • real estate and other real assets
  • floating rate or inflation-linked bonds
  • commodities.

The same goes for volatility. Looking at the portfolio's maximum potential drop helps to optimize a portfolio that aims to avoid this drop. Periodically rebalancing the portfolio, bringing asset classes to their target allocations, is a powerful mechanism.


Maintaining savings levels or even strengthening

I would say that savings are one of the success factors towards financial independence, but in a scenario like the current one, it becomes even more important. The wallet thanks you and the rebalancing process is done even more efficiently.

If we are investors with low risk tolerance and little desire for volatility, we have to be prepared for low interest rates and therefore we have to save more. Saving more, or above normal, has the advantage of reducing the need to take risks.


Set goals

If we set concrete goals, we can build a portfolio specifically for each goal. Saving and investing for the goal of buying a car 5 years from now is different from saving and investing for retirement 20 years from now. We can save and invest for both purposes and build portfolios geared towards each.

This guideline makes it possible to control asset risk and volatility. In addition, we will be more immune to daily variations as we know that we are saving and investing towards a goal. We will be more focused on time and where we are going to “hide” (apply) the savings, that is, on the assets that will help achieve the goals.


Our portfolio is unique

This factor is essential. We are under a lot of external pressure to invest in this or that asset. We will always meet someone who has invested well and is highly profitable, but we will hardly know who is investing badly and losing a lot of money. The ideal is to invest in what is our plan, which is unique and adjusted to our life. It is important to be aligned and focused with our investment profile, objectives, risk tolerance and preferences.

Sometimes the best strategy is the one we can follow or replicate, not the perfect, rational strategy. A good strategy that we can follow is preferable to a perfect strategy that we cannot follow.

Decisions are not easy. But we have to know that the daily volatility in little or nothing should change our plan. This is our insurance. Insurance is a way of mitigating risk by passing it on to another entity, but it does not eliminate the risk. He continues to exist. In the case of a portfolio, there are several types of insurance available to investors: diversification, setting objectives, investing based on these defined objectives, systematic savings, optimism and the time factor.

There are no magic answers, but there are strategies that help control and mitigate volatility and almost all of them depend on us and not on the market itself.

Vítor Ribeiro, CFA
Vítor Ribeiro, CFA

Vítor is a CFA® charterholder, entrepreneur, music lover and with a dream of building a true investment and financial planning ecosystem at the service of families and organizations.

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