For many investors, volatility is simply a euphemism for “losing money.”

That is completely understandable because sharp downward swings in the market can be unnerving; it is basic human nature. Although the market has had an impressive run in recent years, memories linger from the global financial crisis and the dot.com debacle earlier this century. In fact, going back to 1928, the five most volatile years ever recorded by the S&P 500 Index — 2000, 2002, 2008, 2009 and 2011 — have occurred since the start of the millennium.

Volatile periods such as those tend to produce emotional, untimely investment decisions, like selling all one’s stocks at what later turns out to be the market bottom. And volatility on the upside can be equally hazardous to an investor’s wealth, such as when the “irrational exuberance” famously cited by Alan Greenspan kicks in. After all, investments made at or near the top of the market are particularly vulnerable to losses during the next downdraft.

 

The costs of buying high and selling low

Over the past decade or so, the tendency of investors to buy high and sell low has been all too common. As one example, Exhibit 1 on page 2 shows how investors have piled into equity funds following two-year periods of strong market performance, often just in time to then have to endure two years of falling prices or subpar performance.

Research firm Dalbar examined the experience of the average equity mutual fund investor over an even longer period — the 20 years ended December 31, 2011, taking into account the timing of fund purchases and sales. Dalbar found that the average fund investor had an average annual return of 3.83% over the two decades, compared with 9.14% for the S&P 500 Index — more than five percentage points less1. A $100,000 investment in the average investor’s portfolio would have earned $362,955 less than an equal investment in the S&P 500 Index over that same 20-year span.

 

 

As further illustration, consider how cruel the laws of arithmetic can be when it comes to recovering from a steep investment loss. Ideally, a loss of 50% could be recouped with a subsequent gain of 50%. In reality, since half of your investment vanishes in this scenario, it is easy to see that the remainder has to double (i.e., increase by 100%) simply to get back to where you started. The same is true to a greater or lesser degree in other loss scenarios, highlighting the risks of buying at or near a market peak.

Of course, the flip side of the coin — selling at or near a market trough — can be just as risky. After the S&P 500 Index bottomed in March 2009, the market went on to rebound by 45% over the ensuing six months. So an investor with a big loss from the financial crisis who sold his or her stocks in March 2009 and shifted to cash would have also incurred a significant opportunity cost. This underscores why it makes sense to recognize the dangers of emotion-driven investing and to take appropriate measures to remove emotion from the investment decision process.

 

Managing volatility with a range of tools

The main takeaway here is that investors who are unduly influenced by emotion frequently wind up being managed by market volatility, and have often been saddled with inferior performance as a consequence. The good news is that it doesn’t necessarily have to be that way.

Eaton Vance believes that sound investment strategy should let volatility be managed by investors, offering the tools to help "smooth out the ride" and potentially improve portfolio returns. While conventional wisdom tells us that the lower the risk, the lower the return, the opposite may hold when defining risk in terms of volatility. As Exhibit 2 on the next page shows, lower-volatility investments may actually deliver greater compounded returns over a multiyear period than higher-volatility investments.

But as important as so-called “downside protection” often is, one can argue that it’s only one aspect of managing volatility. In our judgment, investors cannot be successful over the long term in today’s complex, dynamic markets if they simply try to “protect” themselves from future market shocks, especially since no one knows when or why the next one will hit.

So what’s an investor to do? While the most suitable strategies for dealing with volatility are apt to vary from one investor to another, one thing seems fairly certain to us: There is no single, “silver-bullet” solution to the challenge of managing volatility over the long term. Instead, a creative, comprehensive approach may be required — one that incorporates both defensive elements as well as more offensive ones.

 

 

With that in mind, we suggest that investors trying to build a volatility-management strategy consider more than one of the following alternatives:

1. Absolute return funds to reduce volatility: As their name implies, absolute return funds seek to achieve positive total returns (i.e., capital appreciation plus any income distributions) regardless of which direction the stock and bond markets move. More precisely, the objective is generally to earn a few percentage points above the “risk-free” rate of return in most market environments. That may not always happen every month or even every year, but there should be some consistency in returns over time.

Absolute return investing is designed to exhibit low correlation to trends or beta in traditional asset classes such as stocks and bonds. For that reason, an allocation to an absolute return fund may help:

  • Complement other holdings within a diversified investment portfolio;
  • Limit downside risk and mitigate portfolio volatility, particularly when stocks are out of favor;
  • Grow and preserve wealth in the pursuit of long-term financial goals.

2. Flexible “go anywhere” strategies to navigate volatility: Some investment strategies have a flexible mandate that allows them to invest globally across a variety of asset classes, regions, sectors, styles and market capitalizations. In our view, such strategies work best when they have the ability to swiftly adjust tactical allocations as evolving market conditions dictate. For example, if the manager believes a certain sector is underestimated by investors, he or she should be able to reposition the portfolio accordingly in an effort to benefit from that perceived opportunity.

Ideally, however, the manager of a flexible strategy should be equally focused on managing volatility and risk as on seeking to capitalize on overlooked opportunities. Among other things, this may entail:

  • Trying to maintain a globally diversified portfolio to spread out risk exposure;
  • Identifying underlying economic themes so as to respond to the economic causes of volatility;
  • Taking proactive steps to avoid “bubbles” or other risks in different segments of the market.

3. Rules-based strategies to exploit volatility: Instead of attempting to minimize volatility, some global investment strategies employ a rules-based approach that seeks to perform well in turbulent markets by harnessing and exploiting volatility. The thinking behind such strategies is that volatility is not something to be feared, but rather embraced and viewed opportunistically.

Adhering to a disciplined, rules-based approach can help minimize the role of emotion in investment decisions, thereby potentially neutralizing volatility and enhancing portfolio returns. A good example of this type of approach is using systematic portfolio rebalancing to determine market entry and exit points.

Portfolio rebalancing operates on the principle of “mean reversion” — the theory that asset prices and returns eventually drift back to their historical averages — and is designed to buy into market weakness and sell into market strength. In this manner, rebalancing may enable investors to capture the premiums created when market volatility gives rise to temporarily undervalued or overvalued situations.

4. High-quality stocks to weather volatility: There are equity strategies that focus primarily on stocks of high-quality companies that have historically been prone to less volatility than their lower-quality counterparts. High-quality stocks can be found across market capitalizations and investment styles and have typically been assigned a high quality ranking by one or more reputable, independent firms.

Quality rankings are generally based on an evaluation of a company’s financial strength and fundamental characteristics over a given time period. Specifically, the hallmarks of a high-quality company may include one or more of the following:

  • A proven track record of sustained, stable earnings growth;
  • A healthy corporate balance sheet with superior cash flows;
  • A history of steady dividend payouts to shareholders.

Companies with these and other traits have often demonstrated resilience through changing economic cycles and may help weather stock-market fluctuations and broad market declines.

 

Conclusion

No one knows whether market volatility will increase or decrease in the period ahead; the level of volatility is itself volatile. If history is any guide, however, investors without a well-crafted, multi-pronged strategy for effectively managing volatility are more likely to be managed by it — quite possibly at the expense of their long-term investment success. Experienced financial advisors and professional investment managers can be key allies in developing and overseeing such a strategy based on each investor’s personal goals and risk tolerance.

1Source: “Quantitative Analysis of Investor Behavior,” DALBAR, Inc. QAIB uses monthly fund data to calculate investor returns as the change in assets after excluding sales, redemptions and exchanges. This method of calculation captures realized and unrealized capital gains, dividends, interest, trading costs, sales charges, fees, expenses and any other costs. After calculating investor returns in dollar terms, two percentages are calculated for the period examined: total investor return rate and annualized investor return rate. Total return rate is determined by calculating the investor return dollars as a percentage of the net of the sales, redemptions and exchanges for the period. Past performance is no guarantee of future results.

 

 

About Eaton Vance

Eaton Vance Corp. (NYSE: EV) is one of the oldest investment management firms in the United States, with a history dating to 1924. Eaton Vance and its affiliates offer individuals and institutions a broad array of investment strategies and wealth management solutions. The Company’s long record of exemplary service, timely innovation and attractive returns through a variety of market conditions has made Eaton Vance the investment manager of choice for many of today’s most discerning investors.

About Risk

Volatility: While certain Funds have a targeted annual performance volatility range, its actual, or realized, volatility for longer or shorter periods may be materially higher or lower than the target range depending on market conditions. No Fund is a complete investment program and you may lose money
investing in a Fund. Regulatory changes may adversely affect securities markets and market participants, as well as the Fund’s ability to implement its strategy. A Fund may engage in other investment practices that may involve additional risks and you should review the Fund prospectus for a complete description.

The views expressed in this Insight are current only through the date stated at the top of this page. These views are subject to change at any time based upon market or other conditions, and Eaton Vance disclaims any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Eaton Vance are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Eaton Vance fund.

Before investing, investors should consider carefully the investment objectives, risks, charges and expenses of a mutual fund. This and other important information is contained in the prospectus and summary prospectus, which can be obtained from a financial advisor. Prospective investors should read the prospectus carefully before investing.

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