I received a question yesterday about volatility of broad-based ETFs. The question was from an investor who has observed that they seem to be as volatile as individual stocks. He likes the idea of reducing volatility but maybe is unsure whether ETFs actually do reduce volatility.

I don’t think I agree with the general nature of his sentiment that broad-based products are as volatile as he thinks but that is his perception so it becomes his reality.

Obviously there are some stocks that are less volatile than the index to which they belong and also this summer has generally been more volatile than most of the last few years.

That fairly obvious answer aside the question drifts into portfolio construction. I write a lot about increasing or reducing volatility, I am talking about the entire portfolio not the individual components. I do not know the mindset of the person leaving the question but it is common for people to focus on the volatility of the individual holdings as opposed to the volatility of the overall portfolio.

Most of the accounts I manage have 40-45 holdings. There are two reasons why they will not all go up all the time. One reason is that if the do all go up together I would expect they will all go down together (the context here is weeks not on a given day). Secondly, if you buy 40 stocks it is not realistic to expect you will be right about all 40.

The sooner you can recognize an actual mistake and get rid of it the better but not every stock that goes down is a mistake. Back to financials; I expected the group to lag for reasons I have spelled out many times already. So this sector becomes a place to reduce volatility so maybe that means no small caps, no investment banks and no exchanges.

Not having those three sub-sectors allowed for less volatility than I might have otherwise had.

Materials is a sector that I have expected to do well and so adding some volatility seems like a reasonable idea, which is what I have done (this has been disclosed many times as well).

Believing we are close to the end of the cycle and that the chance for corrections is a little higher than normal I have taken steps to reduce the overall volatility even if some of the things I own are volatile. I have a little more cash than normal, I have favored dividends and I maintain a position in the double short fund. In addition to stock selection, these are tools to manage volatility.

The summer was a wild ride but the things outlined here (really what I have been writing about all summer) allowed clients to have a much smoother ride and luckily the places where I do have volatility have had a nice snapback effect (that I have also written about many times), I will detail performance in this weekend’s video.

One of the reasons I specifically do not favor broad-based products is because of the fine tuning that is possible with narrower products. As TomK mentioned the other day not everyone has the time to construct a portfolio with so many moving parts–very fair point. An assumption I have made many times before is that the people who are inclined to seek out a blog for stock market commentary are generally more able/likely to spend enough time to come up with more than 80% SPY and 20% EFA.

Last 5 posts by Roger Nusbaum

• The Big Picture for the Week of November 15, 2009 - November 14th, 2009
• Process Drilldown - October 23rd, 2009
• Sunday Morning Coffee 10-18-09 - October 18th, 2009
• A Little Followup From This Morning - October 8th, 2009
• Wednesday Roundup - October 7th, 2009