Why Common Diversification May Not Protect You From Major Market Volatility

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Includes: GLD, UVXY, VIXY, VXX
by: Matthew Allbee

Summary

In planning how to deal with increased volatility in the coming weeks, it is important to understand how different risk management techniques can affect your portfolio.

For instance, further diversifying an already diversified portfolio can do more harm than good.

In this article, I explain why that is and some of the other ways that investors can protect themselves against price swings.

Planning for what could be an extended period of volatility after the Brexit leave vote that shocked markets Thursday night, you may suddenly be finding yourself out of your risk comfort-zone. Prices are swinging around violently, making your portfolio's value much less stable than you want.

To combat this, many investors are searching for ways to bring their risk profile back in line with what they are comfortable with. This can be seen in the soaring prices of safe-havens such as gold futures, VIX products, and Treasury bonds.

For the small investor, when the topic of risk management is mentioned, increasing diversification is almost a reflex. Certainly, diversification can help to reduce the volatility of a portfolio; although over-diversified portfolios may not be much better than under-diversified ones.

Simple diversification can end up being too dull of a tool for dealing with extraordinary volatility. By choosing to further diversify an already diversified portfolio in response to such an event as Brexit, you run the risk of diversifying away more of your return potential than risk.

This is because volatility throughout international markets is highly correlated. For instance, a small-cap investor in the UK may think it wise to diversify into other countries, hoping to escape the huge volatility spikes in the UK. In doing so, he gives up a portion of potential return for the benefit of reduced volatility risk.

This is a smart move if the gain in risk reduction is larger than the loss in return potential, but it's unlikely that this is the case. The investor has already given up some potential return by increasing their level of diversification. At the same time, their reduction in risk will be dampened by the correlated volatility of the two markets. They will probably only benefit from the move if the instrument they are entering into is a better overall investment than the one sold (in which case it would probably make sense to make the trade regardless).

Which is why the value of safe-haven assets spike with volatility. Positive-yield Treasury notes contain practically zero-risk if held until maturity. Depending on an investors desired risk profile, allocating a portion of the portfolio to Treasury notes could completely re-align the risk/reward ratio.

For those more comfortable with risk, Treasury notes may be "too safe" for any allocation to fit. These investors may choose to invest in gold futures, safe-haven currencies such as the U.S. Dollar and Swiss Franc, or VIX products; each of which has historically moved opposite to equity markets during high volatility events.

These last products differ from Treasury notes in that they also carry risk - sometimes substantially so. For instance, VIX (NYSEARCA:UVXY), (NYSEARCA:VXX) products can easily swing 50% in a single session. Depending on your perspective, this could either mean you won't need as large of an allocation to hedge against volatility risk or that you should stick with safer products.

In considering which investment products would best serve as a hedge for you, you'll want to look at the contrasting characteristics between the choices. I've somewhat gone over this with regards to Treasury notes. As another example, let's also go over the characteristics of gold futures and VIX derivatives.

Gold

Gold (NYSEARCA:GLD) is often bought as a way to escape falling asset prices; with the belief being that gold will maintain a stable value. Because of this, gold can continue to increase in value for long periods of time if it is believed that prices will continue to fall. This behavior leads to an asset that can provide a long-term boost in a long bear market.

Because of this long-term trending behavior, gold can act as a hedge against long-term market disruptions. For instance, gold prices nearly doubled during the Great Recession. Because of its comparably slow-and-steady nature (compared to VIX products for instance), though, gold may not be the best hedge against short term shocks. The price of gold was only up 1.08% in October 1987; the month of the stock market crash.

VIX Derivatives (Options and Futures)

VIX derivatives, ,(NYSEARCA:VIXY), which track the CBOE VIX index, are often used to trade how fearful the market is. The VIX index is a calculation of the implied volatility of the market - the future volatility as predicted by options set to expire at that future time. When options market makers believe the stock market will fall during that period, they increase the implied volatility of options, which causes an increase in the VIX.

The VIX index is very volatile, and thus so are its derivatives. In fact, the VIX now even has its own volatility index which shows that implied 30-day volatility of the VIX is consistently above 130. This volatility leads to VIX derivatives being very responsive to fear in the market, fairly regularly moving 50% in a single day.

But, the VIX is mean-reverting. The higher the VIX goes, the less likely it will go higher. So, VIX derivatives probably won't fair too well in protecting against a long-term bear market.

Instead you may want to own VIX derivatives when you wish to protect your portfolio against significant, quickly-unfolding market shocks; such as the Brexit vote, major economy debt default, or the breakout of a major war.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in VXX, GLD over the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.