Reducing volatility of a stock portfolio (alternative to equity:bonds allocation?)

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latetodinner
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Reducing volatility of a stock portfolio (alternative to equity:bonds allocation?)

Post by latetodinner »

I've been considering some means of reducing the volatility of my portfolio's value (at the cost of lower returns, naturally) - improving risk/return ratio. Ideally I'd like to reduce volatility as much as possible with only a minor cost to long-term returns.

(Actually, volatility is not the same as risk, is it? A portfolio can be very stable for many years and then suddenly nose-dive. Historically-low volatility does not mean low risk)

Why give up on long-term returns? What is my goal?
A. Better psychological safety. Both on the upside (fear of the coming calamity) and during downsides.

B. Safer withdrawal - mostly for big one-time purchases. The SWR will probably be the same for a low-volatility-low-return portfolio as for a high-volatility-high-return portfolio, but planned purchases which expect to withdraw >25% of the total might be a different story.

C. Similarly, more predictable outcomes. I'm hoping to be able to start early retirement in 7-8 years (assuming modest returns). I'm worried of suddenly postponing that by several years due to a sudden downturn. This is actually (A) again, since if the market falls I should be able to expect higher returns and go ahead anyway.


Ideas:
1. Diversify into bonds. The obvious solution and the one most commonly repeated. Guaranteed to reduce downturns, if using short-term government bonds. My issue with this solution is that short-term government bonds in my local currency have low-to-zero yield, possibly negative after taxes and trade costs. So this becomes equivalent with 'invest a smaller amount' - risk/return ratio is not improved.

2. Low-correlating assets (gold, commodities, real estate). Physical real estate is ruled out (it's not a stock), and real estate stocks might behave much like regular stocks. I'm not a big fan of gold/commodities/etc. - zero or negative expected returns and might move with the market in the next downturn. There is one option there I like:

3. Long-term bonds (20+) - positive expected return, historically low correlation with stocks (negative, in big downturns). I'm fond of this approach, but I worry the bonds don't have much upside left - yields are already very low. EDV has 2.5% yield, and 20+ year bond in my local currency trades at under 2%
(Bonds might not be better than gold/commodities in their future negative correlation with stocks at downturns, but at least they have positive expected return)

4. Put options. Originally came across this "idea" from a book and, recently, a small article about Nassim Taleb. The article suggested a strategy where 0.5% of the portfolio is kept in 2-month far-OTM put options, rolled monthly. Seeing as such options lose value very quickly, I can't see how this costs much less than 6% of the portfolio every year! Sounds extremely expensive. I'd love to be able to run some kind of backtesting on this - I have no data source with historical prices for options. Any ideas? Easy tools I can use? (I can make use of machine-readable data)

5. If (4) mostly works because the option's price goes up, even if the underlying asset doesn't reach the strike price, then VIX should be a good proxy. This has an advantage that it can be backtested somewhat :) but the data sources for that are also minimal (for ETFs/ETNs that track the VIX). A significant disadvantage is that I'm venturing into realms I don't understand well enough (does not improve psychological safety)

Your thoughts on these and other ideas on reducing volatility of a portfolio that's mostly VT?
My tax situation is pretty weird
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Re: Reducing volatility of a stock portfolio (alternative to equity:bonds allocation?)

Post by latetodinner »

Can I use leverage to reduce the cost of (4)? Supposedly it'd be safer than a regular leveraged 100%-stocks portfolio, as the put options provides protection against the very worst
My tax situation is pretty weird
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Re: Reducing volatility of a stock portfolio (alternative to equity:bonds allocation?)

Post by watchnerd »

Currencies are another negatively correlated asset.

I fairly recently added a currency basket to my portfolio because I didn't want to add more LTT and thus take on more duration risk.

USDU and UUP have had negative correlations with VT.
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Re: Reducing volatility of a stock portfolio (alternative to equity:bonds allocation?)

Post by nisiprius »

A bond allocation may be brute force but it works. It is a powerful, robust, reliable tool for cutting volatility and other aspects of risk (such as maximum drawdown during 2000-2003, or 2008-2009, or the first half of 2020). Yes, it reduces return.

Yes, of course, it would be nice to reduce volatility without giving up any return, but I would look critically at claims that say it can be done. How much, and how reliably?

In backtesting, in theory, and possibly in practice, you can "reduce" volatility with uncorrelated assets, but in comparison to using bonds, the amount of volatility reduction is relatively small and the effect is much less robust or reliable.

For example, this doesn't surprise anyone after the fact, but before 2008 REITS were widely touted as having similar risk and return to other stocks, but low correlation with them. The perfect diversifier. However, here is a comparison between a plain Total Stock (blue), and Total Stock "diversified" with 25% REIT index (red). In 2008-2009, the "low correlation diversifier" turned out to have high correlation and made things worse. That's what I mean by "not robust" and "unreliable."

Some may say "well, it didn't make it much worse," which is correct. However, in most cases I've looked at, when it did make things better, it didn't make them much better, either. Or, it made them better during one time period, and worse in another. Don't forget that low correlation doesn't just mean "goes up when stocks go down," it also means "goes down when stocks go up." Or, realistically, not even that: when stocks go down, it sometimes goes down less, sometimes goes down more; when stocks go up, it sometimes goes up less, sometimes goes up more; and the statistical balance over rather long periods of time has been moderately favorable overall.

Source

Image
Last edited by nisiprius on Mon Apr 19, 2021 10:35 am, edited 2 times in total.
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Re: Reducing volatility of a stock portfolio (alternative to equity:bonds allocation?)

Post by dbr »

latetodinner wrote: Sun Apr 18, 2021 7:55 am
(Actually, volatility is not the same as risk, is it? A portfolio can be very stable for many years and then suddenly nose-dive. Historically-low volatility does not mean low risk)
The definition of risk in investment finance is volatility measured by the standard deviation of periodic (usually annual) returns. Note that volatility of annual returns compounds to high uncertainty of long term result.

Yes, it is true that the time series of investment performance of a portfolio can be complex. The classic illustration is secular bull and bear markets in stocks. There is a whole literature on panics and crashes as well.

It is probably going to be difficult to find many examples of stable portfolios that truly experience a sudden deviation in return, but it can happen. It probably happens more often when the assessment of stability is done over too short a time line.
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Re: Reducing volatility of a stock portfolio (alternative to equity:bonds allocation?)

Post by Forester »

latetodinner wrote: Sun Apr 18, 2021 7:55 am I've been considering some means of reducing the volatility of my portfolio's value (at the cost of lower returns, naturally) - improving risk/return ratio. Ideally I'd like to reduce volatility as much as possible with only a minor cost to long-term returns.

(Actually, volatility is not the same as risk, is it? A portfolio can be very stable for many years and then suddenly nose-dive. Historically-low volatility does not mean low risk)

Why give up on long-term returns? What is my goal?
A. Better psychological safety. Both on the upside (fear of the coming calamity) and during downsides.

B. Safer withdrawal - mostly for big one-time purchases. The SWR will probably be the same for a low-volatility-low-return portfolio as for a high-volatility-high-return portfolio, but planned purchases which expect to withdraw >25% of the total might be a different story.

C. Similarly, more predictable outcomes. I'm hoping to be able to start early retirement in 7-8 years (assuming modest returns). I'm worried of suddenly postponing that by several years due to a sudden downturn. This is actually (A) again, since if the market falls I should be able to expect higher returns and go ahead anyway.


Ideas:
1. Diversify into bonds. The obvious solution and the one most commonly repeated. Guaranteed to reduce downturns, if using short-term government bonds. My issue with this solution is that short-term government bonds in my local currency have low-to-zero yield, possibly negative after taxes and trade costs. So this becomes equivalent with 'invest a smaller amount' - risk/return ratio is not improved.

2. Low-correlating assets (gold, commodities, real estate). Physical real estate is ruled out (it's not a stock), and real estate stocks might behave much like regular stocks. I'm not a big fan of gold/commodities/etc. - zero or negative expected returns and might move with the market in the next downturn. There is one option there I like:

3. Long-term bonds (20+) - positive expected return, historically low correlation with stocks (negative, in big downturns). I'm fond of this approach, but I worry the bonds don't have much upside left - yields are already very low. EDV has 2.5% yield, and 20+ year bond in my local currency trades at under 2%
(Bonds might not be better than gold/commodities in their future negative correlation with stocks at downturns, but at least they have positive expected return)

4. Put options. Originally came across this "idea" from a book and, recently, a small article about Nassim Taleb. The article suggested a strategy where 0.5% of the portfolio is kept in 2-month far-OTM put options, rolled monthly. Seeing as such options lose value very quickly, I can't see how this costs much less than 6% of the portfolio every year! Sounds extremely expensive. I'd love to be able to run some kind of backtesting on this - I have no data source with historical prices for options. Any ideas? Easy tools I can use? (I can make use of machine-readable data)

5. If (4) mostly works because the option's price goes up, even if the underlying asset doesn't reach the strike price, then VIX should be a good proxy. This has an advantage that it can be backtested somewhat :) but the data sources for that are also minimal (for ETFs/ETNs that track the VIX). A significant disadvantage is that I'm venturing into realms I don't understand well enough (does not improve psychological safety)

Your thoughts on these and other ideas on reducing volatility of a portfolio that's mostly VT?
So instead of 60% VT 40% BND

30% VT
25% ACWV
5% GDX

25% BND
15% GLD
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Re: Reducing volatility of a stock portfolio (alternative to equity:bonds allocation?)

Post by nisiprius »

Forester wrote: Mon Apr 19, 2021 10:32 am...(Actually, volatility is not the same as risk, is it? A portfolio can be very stable for many years and then suddenly nose-dive. Historically-low volatility does not mean low risk)...
Volatility is one kind of risk. Volatility is an important kind of risk.

Warren Buffett is often misquoted on this. He's misquoted as having said "volatility is not risk," but his actual words were:
That lesson has not customarily been taught in business schools, where volatility is almost universally used as a proxy for risk. Though this pedagogic assumption makes for easy teaching, it is dead wrong: Volatility is far from synonymous with risk.
"Far from synonymous with" is far from synonymous with "is not."

The other thing that gets overlooked by people trying to downplay volatility is that even though it is not the only kind of risk, it actually is pretty well associated with other kinds of risk. For example, some time ago I simply took PortfolioVisualizer's numbers for "StDev" (pure volatlity) and "max drawdown," a risk metric I personally relate to.

So, while you may believe that you don't care much about standard-deviation "volatility," in real life by and large the investments that have a lot of short-term volatility are also investments that have other dimensions of risk, too.

Full posting with details
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Re: Reducing volatility of a stock portfolio (alternative to equity:bonds allocation?)

Post by latetodinner »

Thanks everyone for the thoughtful replies!
nisiprius wrote: Mon Apr 19, 2021 10:43 am The other thing that gets overlooked by people trying to downplay volatility is that even though it is not the only kind of risk, it actually is pretty well associated with other kinds of risk. For example, some time ago I simply took PortfolioVisualizer's numbers for "StDev" (pure volatlity) and "max drawdown," a risk metric I personally relate to.
Yes! In fact I think minimizing "max drawdown" is exactly what I'm after. Although I'd still have psychological issues with a portfolio whose return series looks like '0, 0, 0, 20, 0, 0, ...' even if the CAGR is good.
(I guess that makes sense. That 20 must come as a surprise, otherwise the asset would rise earlier in expectation of it. If the market can't expect that return, neither can I)

Thanks for the link - I've perused the thread, plan to read it thoroughly later.
Can you calculate the SWR from the CAGR and volatility?
Forester wrote: Mon Apr 19, 2021 10:32 am So instead of 60% VT 40% BND

30% VT
25% ACWV
5% GDX

25% BND
15% GLD
Thanks!
ACWV - I hold a bit of the Irish-domiciled equivalent (in a tax deferred account - am Non-US investor), as part of a "10% gambling" section. Intent is to find out what it "feels like" to hold it for a few years, then decide whether to allocate it a bigger segment.
I really like the idea, but kind of worry there's a risk involved with picking stocks out of the index (that's what the fund does, isn't it?). I guess the standard deviation speaks for itself - it definitely seems to do well (higher sharpe ratio, in the long term). It's slightly less tax efficient (higher dividends than general stocks) but I have plenty of room for it in my tax deferred account if I can convince myself it's not more risky than VT

GDX - doesn't look that great. GLD looks better, but also a bit lacklustre - they have low correlation with VT, but also low returns overall. I'll have to give it a more thorough look.

nisiprius wrote: Sun Apr 18, 2021 4:20 pm Yes, of course, it would be nice to reduce volatility without giving up any return, but I would look critically at claims that say it can be done. How much, and how reliably?
Please don't strawman me as someone looking for a free lunch. I made it clear I expect lower long-term returns if I reduce volatility (otherwise long-term investors would do the same, and I recognize that stocks is the highest-performing asset in the long term)
nisiprius wrote: Sun Apr 18, 2021 4:20 pm In backtesting, in theory, and possibly in practice, you can "reduce" volatility with uncorrelated assets, but in comparison to using bonds, the amount of volatility reduction is relatively small and the effect is much less robust or reliable.
Well, bonds is also an uncorrelated asset, isn't it? :)
Are we talking about bonds as in short-duration, zero-real-return bonds? In which case it's the same as "not investing" that money, is it not? I can put away money and get CPI-indexed 0% interest at the bank.
Intermediate duration? Long? I mentioned EDV - it's hard to call it a low-volatility instrument. But I keep seeing claims that it reduces the volatility of holding VT (as it goes up when investors panic-exit the market).

watchnerd wrote: Sun Apr 18, 2021 3:46 pm USDU and UUP have had negative correlations with VT.
Thanks! I haven't heard of that notion. I'll take a look at that, too (though I have reservations about instruments with zero expected return)

Short-term bonds have (roughly) zero return, zero volatility and meaningless correlation (correlation is meaningless if the instrument moves neither up nor down). (this is a temporary condition, I believe, due to zero interest rates. When they're high bonds behave quite differently).
Then there's these other instruments - currency, gold, etc. - with zero return and high volatility. That should make them no worse than bonds, in the long term, and better in the short term if the correlation is negative. And of course worse if it is positive :)
My tax situation is pretty weird
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Re: Reducing volatility of a stock portfolio (alternative to equity:bonds allocation?)

Post by nisiprius »

latetodinner wrote: Mon Apr 19, 2021 12:23 pm...But I keep seeing claims that it reduces the volatility of holding VT (as it goes up when investors panic-exit the market)...
"Reduces?" As in "an intrinsic characteristic that can be confidently expected to persist?"

Or "would have reduced--over the specific time period 2000-present?"

Before the correlation was negative for twenty years, it was positive for thirty-five. If there is a rational, reliable, robust explanation in investor psychology, why was investor psychology different before 2000?

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Re: Reducing volatility of a stock portfolio (alternative to equity:bonds allocation?)

Post by dbr »

latetodinner wrote: Mon Apr 19, 2021 12:23 pm
Can you calculate the SWR from the CAGR and volatility?

Yes, use the MC simulation in Portfolio Visualizer and choose parametrized returns and select the expected return and the expected volatility. Note you also have to make the same adjustments to how inflation is handled in that model. Also expected return is the average annual return and not the CAGR. The two are the same only if there is no variation in return from year to year.

The next step, though, is to recognize that expected return and standard deviation of return cannot be independently adjusted in the case of real investments. You could enter selections from an efficient frontier curve if you have one that you think applies.
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Re: Reducing volatility of a stock portfolio (alternative to equity:bonds allocation?)

Post by dbr »

latetodinner wrote: Mon Apr 19, 2021 12:23 pm
Well, bonds is also an uncorrelated asset, isn't it? :)
Are we talking about bonds as in short-duration, zero-real-return bonds? In which case it's the same as "not investing" that money, is it not? I can put away money and get CPI-indexed 0% interest at the bank.
Intermediate duration? Long? I mentioned EDV - it's hard to call it a low-volatility instrument. But I keep seeing claims that it reduces the volatility of holding VT (as it goes up when investors panic-exit the market).


Short-term bonds have (roughly) zero return, zero volatility and meaningless correlation (correlation is meaningless if the instrument moves neither up nor down). (this is a temporary condition, I believe, due to zero interest rates. When they're high bonds behave quite differently).
Then there's these other instruments - currency, gold, etc. - with zero return and high volatility. That should make them no worse than bonds, in the long term, and better in the short term if the correlation is negative. And of course worse if it is positive :)
The diversification benefit depends not only on lack of correlation but also on the return and volatility of the assets. As you point out correlation is meaningless if there is no variation. The best diversifier for high stock allocations is long bonds that have high return and high volatility. If you do that the portfolio may become more efficient but will also high risk. If you want to suppress risk you add holdings that have low volatility, but one might sat this is diluting risk rather than diversifying it. The formulas illustrating the idea are here: https://financetrain.com/how-to-calcula ... nd-return/
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Re: Reducing volatility of a stock portfolio (alternative to equity:bonds allocation?)

Post by watchnerd »

latetodinner wrote: Mon Apr 19, 2021 12:23 pm
watchnerd wrote: Sun Apr 18, 2021 3:46 pm USDU and UUP have had negative correlations with VT.
Thanks! I haven't heard of that notion. I'll take a look at that, too (though I have reservations about instruments with zero expected return)

Short-term bonds have (roughly) zero return, zero volatility and meaningless correlation (correlation is meaningless if the instrument moves neither up nor down). (this is a temporary condition, I believe, due to zero interest rates. When they're high bonds behave quite differently).
Then there's these other instruments - currency, gold, etc. - with zero return and high volatility. That should make them no worse than bonds, in the long term, and better in the short term if the correlation is negative. And of course worse if it is positive :)
They're not quite zero nominal return, at least USDU isn't, as there is a smidgeon of yield from the T-bills.

I'm not sure it's a 'forever' holding for me, but with cash paying what it is, it's an interesting option at the moment.

And it has a duration of 0, so you're not taking on even more interest rate risk, which I find important if you're already holding Long Treasuries.
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Re: Reducing volatility of a stock portfolio (alternative to equity:bonds allocation?)

Post by secondopinion »

nisiprius wrote: Mon Apr 19, 2021 12:44 pm
latetodinner wrote: Mon Apr 19, 2021 12:23 pm...But I keep seeing claims that it reduces the volatility of holding VT (as it goes up when investors panic-exit the market)...
"Reduces?" As in "an intrinsic characteristic that can be confidently expected to persist?"

Or "would have reduced--over the specific time period 2000-present?"

Before the correlation was negative for twenty years, it was positive for thirty-five. If there is a rational, reliable, robust explanation in investor psychology, why was investor psychology different before 2000?

Image
Thank you for this graph. This support my opinion of why I disagree with portfolios that have treasury bonds as their only bond holdings. When the correlation is positive, the advantage of treasuries is reduced down to credit risk management (being solely a risk-return question). I wonder how corporate bonds fared during these positive correlation times.
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Re: Reducing volatility of a stock portfolio (alternative to equity:bonds allocation?)

Post by latetodinner »

secondopinion wrote: Mon Apr 19, 2021 4:44 pm I wonder how corporate bonds fared during these positive correlation times.
[Purely theory, I don't have data]
Wouldn't bonds backed by companies behave much like those companies' stock, in big downturns?
If the market thinks the company's chances of bankruptcy increased, that would reflect badly on both its stock and bonds.
(Though stock first, as bond holders are more privileged and may get paid despite bankruptcy)
(Also, if the market only expects the company to underperform, it makes sense for its stock to go down while its bond rise)
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Re: Reducing volatility of a stock portfolio (alternative to equity:bonds allocation?)

Post by secondopinion »

latetodinner wrote: Tue Apr 20, 2021 1:41 am
secondopinion wrote: Mon Apr 19, 2021 4:44 pm I wonder how corporate bonds fared during these positive correlation times.
[Purely theory, I don't have data]
Wouldn't bonds backed by companies behave much like those companies' stock, in big downturns?
If the market thinks the company's chances of bankruptcy increased, that would reflect badly on both its stock and bonds.
(Though stock first, as bond holders are more privileged and may get paid despite bankruptcy)
(Also, if the market only expects the company to underperform, it makes sense for its stock to go down while its bond rise)
Behave like stocks in bankruptcies and market panic, yes; but they are more cushioned (do not look at bond ETFs in March 2020; they are discounted terribly (or wonderfully if one was buying)). However, it is very well known that they often recover a bit of principal in a bankrupt (remember S&P saying it is about 55% for senior bonds and 45% for the unsecured). If there is a growth lull, then bonds are going to be favorable to stocks.

I agree with the statements above, just that bonds are indeed safer than stocks when you do a direct stock-to-bond comparison.
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Re: Reducing volatility of a stock portfolio (alternative to equity:bonds allocation?)

Post by watchnerd »

secondopinion wrote: Tue Apr 20, 2021 10:39 am just that bonds are indeed safer than stocks when you do a direct stock-to-bond comparison.
Was that ever in dispute?

Saying corporate bonds are riskier than Treasuries doesn't mean they're riskier than stocks.
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Re: Reducing volatility of a stock portfolio (alternative to equity:bonds allocation?)

Post by secondopinion »

watchnerd wrote: Tue Apr 20, 2021 11:48 am
secondopinion wrote: Tue Apr 20, 2021 10:39 am just that bonds are indeed safer than stocks when you do a direct stock-to-bond comparison.
Was that ever in dispute?

Saying corporate bonds are riskier than Treasuries doesn't mean they're riskier than stocks.
Right. I am just stating the clearly obvious truths so that no one is swayed otherwise; it is too common in investing to forget core truths.
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