If you have a very volatile share portfolio, it can be an emotional rollercoaster. Of course, some people love the thrill of rollercoasters – but the rest of us don't want to feel that sense of anxious apprehension every time we check our share portfolios. We just want nice, slow, dependable wealth accumulation. Nothing fancy, just a few extra dollars in our pocket each week will do it.
Luckily for us, there are many quick and easy ways to reduce the volatility of our share portfolios. In this article, I take a look at three options: diversification, defensive shares, and dollar-cost averaging.
1. Diversification
One of the quickest and easiest ways to reduce your portfolio's volatility is to diversify your investments. This essentially means buying many different shares or other investments and combining them into one portfolio.
The share prices of different companies will respond differently to different events. For example, news of an interest rate hike will hurt the share prices of growth companies with higher debt levels, as it increases their borrowing costs. However, it could boost the prices of bank and insurance shares, which tend to benefit from higher interest rates.
If you had a portfolio that only consisted of growth shares, you'd be hurt in this scenario. However, if you also owned some banking and finance shares, the gains in their share prices may have offset your other losses. And so, overall, you would have reduced your portfolio's volatility, simply by being more diversified.
If you don't have much money to invest but still want to diversify your portfolio quickly, exchange-traded funds (ETFs) are a great option. ETFs trade on the ASX much like ordinary shares but are actually investment funds.
Some are designed to track specific indices, like the iShares Core S&P/ASX200 ETF (ASX: IOZ). Others invest in commodities and other asset classes, like the Global X Physical Gold ETF (ASX: GOLD), which – as the name suggests – invests in gold.
2. Defensive shares
OK, so we've agreed that diversification is good if you want to reduce your portfolio's volatility. But what if there was a particular type of share you could buy to help protect yourself if the rest of the market goes belly-up? As a matter of fact, there is: defensive shares.
Defensive shares belong to companies that tend to do well regardless of the state of the broader economy. They might be consumer staples shares like Coles Group Ltd (ASX: COL), healthcare companies like CSL Ltd (ASX: CSL), or telecommunications companies like Telstra Group Ltd (ASX: TLS). These companies all provide goods and services that people rely on daily, so their profitability is less affected by economic downturns.
Think of defensive shares almost as a type of insurance. When the prices of other stocks are tumbling, defensive shares tend to preserve their value. This means that adding a few of them to your portfolio can help it stay buoyant even when market conditions get choppy.
3. Dollar-cost averaging
Another great way to reduce your portfolio's volatility is to follow a dollar-cost averaging ('DCA') investment strategy. Rather than investing one lump sum upfront, proponents of DCA will invest smaller amounts regularly over time, regardless of market conditions.
Sure, that might not sound that earth-shattering, but the magic of this strategy is best illustrated with a simple example.
Let's say you wanted to invest $1,000 in Company A, and you could choose between investing your money as one lump sum now, or as five $200 investments each month for each of the next five months. Let's assume that the current share price is $100, and the prices on the days you make your trades in the next 4 months will be $110, $90, $80, and $95.
If you invested all your money as one lump sum upfront, your shareholding over the next five months would look like this:
| Lump Sum | Month 1 | Month 2 | Month 3 | Month 4 | Month 5 |
| Shares Purchased | 10 | 0 | 0 | 0 | 0 |
| Total Shares | 10 | 10 | 10 | 10 | 10 |
| Market Price | $100 | $110 | $90 | $80 | $95 |
| Value | $1,000 | $1,100 | $900 | $800 | $950 |
In this scenario, you used your $1,000 to purchase 10 shares (each priced at $100) in month 1. By month 5, the price of those shares had dropped by 5% to $95, which meant that the total value of your investment had also dropped by 5%, from $1,000 to $950. Pretty straightforward.
However, an interesting thing happens if you follow a DCA strategy.
| DCA | Month 1 | Month 2 | Month 3 | Month 4 | Month 5 |
| Shares Purchased | 2.0 | 1.8 | 2.2 | 2.5 | 2.1 |
| Total Shares | 2.0 | 3.8 | 6.0 | 8.5 | 10.6 |
| Market Price | $100 | $110 | $90 | $80 | $95 |
| Value | $200 | $420 | $544 | $683 | $1,011 |
In this scenario, you break up your $1,000 into five $200 investments you make each month regardless of the share price. In month 1, you can buy 2 shares with your $200 ($200 investment divided by the $100 share price). In month 2, you can only buy 1.8 shares ($200/$110) because the share price has risen to $110. In month 3, you can buy 2.2 shares ($200/$90) because the share price has fallen to $90, and so on.
Because you can buy more shares when prices are lower, by the end of the 5 months, you would end up with 10.6 shares instead of just 10. This means that the value of your portfolio would be $1,011, a 1% increase on your total investment of $1,000.
In other words, even though the company's stock price is now lower than 5 months ago, if you followed a DCA strategy you'd still be up! Pretty amazing, right?
The Foolish bottom line
In this article, I covered a few strategies you can adopt to reduce your portfolio's volatility. You can diversify your portfolio to hedge against certain macroeconomic risks, you can invest more heavily in defensive shares to protect your portfolio against a downturn, and you can dollar-cost average so that you smooth your returns out over time.
However, the right strategy for you will depend on your risk tolerance and personal circumstances. Carefully consider your investing goals and objectives before investing or changing your portfolio strategy. If in doubt, speak to a financial advisor.
