Lowering Your Exposure To Volatility

The financial markets have been a virtual roller coaster over the past year and market watchers say it is likely to continue, at a minimum, through the end of the year -- not the end of this week!

If you are one of the many investors having trouble stomaching the swings, now may be a good time to scale back on your level of risk.

Kathy Willens / AP

“Now is the chance to reposition your portfolio,” says Barry James, president and portfolio manager of James Advantage Funds.“ When you have a lot of volatility it is an indication that a signification change is about to take place in the market…We think the current volatility is probably a precursor to another significant decline,” he says.

If you're looking for a read on volatility, then get familiar with the Chicago Board Options Exchange Volatility Index, known as the VIX, which experts use to gauge market volatility and what it may mean for future activity.

This index measures the implied volatility of the S&P 500 index options to gauge the expected volatility over the next 30 days and based on recent patterns, there's more volatility to come.

Tim Knepp, chief investment officer of Genworth Financial Asset Management,  says historically the value of the VIX has reached the high 30s before there was investor capitulation.

Until the latest chapter of the year-long Wall Street crisis —the Lehman Brothers  chapter 11 filing, Merrill Lynch's buyout by Bank of America [BAC  Loading...      ()   ] and the government bailout of AIG  —the VIX was in  in the high 20s. On Monday, it broke 30 for the first time since March, when Bear Stearns was collapsing and sold off to JPMorgan Chase [JPM  Loading...      ()   ].

“It will get worse before it gets better,” said Knepp.

Fixed On Fixed Income

"Most investors can ride out volatility for a period of time, but for investors that are particularly sensitive, they need to step back," advises Knepp.

So, if you're in the latter category, what should you do? First, make sure you have enough of your assets allocated to fixed income investments.

James, of James Advantage Funds recommends having at least half of your assets in high quality bonds such as municipal bonds, specifically insured municipal bonds as these have higher yields than U.S. Treasuries.

He adds investors may want to consider municipal bond closed-end funds,  as many are very cheap, selling at a discount to their net asset value, NAV (complete financial glossary), while still providing high quality.

James also says some investors may want to look at longer-term Treasurys, as “they have been a nice safety net” for investors and can provide a way to make money. Year to date they are up about 5% with market down double digits, he said.

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However, Alan Gayle, senior investment strategist for RidgeWorth Investments is more skeptical on U.S. Treasurys, saying that may be “the quintessential quality asset” but yields are very low.

In fact, current returns, he said, are lower than the rate of inflation, which means they are unlikely to meet very many investors’ objectives.

Gayle says investors who want something with less risk but potentially better returns might want to consider international bonds that are dollar hedged. Also, he believes there could be some good opportunities with high-quality, credit-related bonds.

Genworth’s Knepp says that in these volatile times, he employs a combination of fixed-income strategies, remaining conservative in terms of credit quality and duration, either fairly low or ultra short duration.

Some funds that Knepp likes for this type of exposure include the Federated UltraShort Bond Fund , as well as the PIMCO Low Duration Bond Fund, because they both have fairly healthy yields primarily invested in government investment grade bonds.

Picky About Stocks

While increasing your bond exposure could help lessen risk in your portfolio, it is still essential for investors to have exposure to equities. Genworth’s Knepp says investors looking to tweak their equity exposure in favor of less risky investments tend to flock toward value stocks.

This category, however, has historically included hefty exposure to financials, which have been severely damaged and, in Knepp's opinion, are not out of the woods yet.

According to James, one group that investors may want to consider are small cap stocks, which are currently cheaper that the S&P 500, and a group he expects to benefit from the strengthening dollar.

If you’re looking for safer sectors, one group to consider is consumer staples that perform well despite market downturns. This would include companies such as Wal-Mart Stores and BJ’s Wholesale Club, which will continue to see customers in tough times because of their discount prices.

In addition, utilities often have good yields and should benefit from falling energy prices.

According to Gayle, these periods of market stress and turmoil are a good opportunity for investors to revisit their appetite for risk and make small modifications accordingly. However, he adds investors should avoid making major changes to their portfolio based simply on short-term changes in the market.

© 2008 CNBC.com