Theory is one thing, reality is another. In theory, portfolio volatility is reduced by combining assets with low correlation coefficients.
Correlation coefficients range between 1 and -1. A value of 1 indicates perfect positive price correlation. Two assets move in parallel formation. If two assets have a correlation coefficient of 1, combining the two will do nothing to reduce portfolio volatility.
On the opposite end of the spectrum, a correlation coefficient of -1 indicates perfect negative correlation. Two assets correlated at -1 would move exactly opposite to each other. If one were up 50%, the other would be down 50%.
Most asset classes have a correlation of less than 1. For this reason, we combine investments and asset classes – stocks, bonds, cash, commodities, gold – to reduce portfolio volatility.
In theory, combining assets that are uncorrelated works. It’s also frequently the case in reality, but not always. Research shows that in the real world of down markets, when you really want diversification to mitigate losses, asset classes converge closer to 1. We saw this in the stock market correction that occurred in August. Assets that were typically lowly, and even negatively, correlated with stocks dropped – namely, gold, commodities and real estate.
So, typical portfolio diversification works best when you really don’t need it – in a rising or staid market. On the other hand, it tends to break down when you most need it – in a hard market sell-off.
The problem is that most investment portfolios are long-only portfolios. That is, portfolios are constructed to go along with the overall market. They rise when markets rise; they fall when markets fall.
To reduce volatility when it’s most sought – during a hard sell-off – investors need contra assets in their portfolio.
Put options are one. A put option on the S&P 500 will see its price rise if the S&P falls.
Shorting is another contra strategy. Selling short the S&P 500, say through the SPDR S&P 500 ETF (NYSEArca: SPY), will lead to a profit if the S&P 500 falls. (Selling short involves selling an asset today and then hopefully buying it back later at a lower price. It’s the opposite of going long, which most investors do.)
The problem is that many investors are uncomfortable using options. They don’t understand them and don’t want to sail into uncharted waters. The same goes for selling short, which can be further limited by your broker. Sometimes a broker lacks the shares to sell short. Worse, the broker can call in the shares at his discretion, which can lead to an ill-timed cover for the short seller.
Buying an inverse ETF is another option, and a worthwhile one for investors steeped in conventional long-only investing.
An inverse ETF is bought and held just like any stock. The difference is that the inverse ETF moves contra to its corresponding investment. You’re looking at a -1 correlation. One goes up, the other goes down, and vice versa. I’ll demonstrate visually using the ProShares Short S&P500 (NYSEArca: SH) and the S&P 500 index.
There are a plethora of inverse ETFs that cover most business sectors. For investors with a broad-based stock portfolio, a broad-based inverse ETF will do. The ProShares Short S&P500 is obviously broad-based. Investors might also consider the ProShares Short QQQ (NYSEArca: PSQ) and the ProShares Short Russell2000 (NYSEArca: RWM). The first works as a contra investment to the Nasdaq Composite Index; the second works contra to the small-cap Russell 2000 Index.
If you owned a portfolio of index funds corresponding to the S&P 500, the Nasdaq Composite and the Wilshire 2000, you could theoretically remove all volatility by offsetting your index investment with a proportional investment in the corresponding inverse ETF. The reality is, though, you would also remove all possibility of your portfolio appreciating.
You still want to be mostly long, but a sliver of your portfolio allocated to a contra investment, like an inverse ETF, will smooth out the ups and downs in your investment portfolio. This will make for a more comfortable ride over the long haul.
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