Can I mitigate risk in a diversified equity fund portfolio?

Equity funds due to their higher risk, have historically offered the most promising growth over the long term, above other funds that focus on assets such as bonds and cash. In markets that are volatile, where stocks held within some equity funds go both up and then down, how can we reduce the overall equity volatility over the long haul?

Let's review our options:

Asset Allocation

Asset allocation, aims at reducing volatility in a portfolio of mutual funds by shifting the equity allocation at just the right time, relative to other asset classes.

In a volatile market, if one shifts the asset class out of equities to bonds and/or cash prior to resurgence in the overall market, one can lose by trying to automatically time the market. Why is this? Most stocks increase in value through a new bull market period which can begin quickly over several days. By being out of the equity market (in this case at the wrong time) because of reallocating, one could lose the associated gains one might achieve by being more heavily invested in equity funds.

However, asset allocation can still prove successful to help you diversify an equity fund portfolio if the right fund and/or fund manager is selected, once historic performance is proven.

Geographic diversification

Since 2008 it is more difficult to diversify across various countries' markets such as China, the emerging equity markets and/or among markets in more developed markets such as Canada, the USA, or the stronger European nations. Why is this more difficult to achieve?

Global equity markets are more closely correlated than they were five or ten years ago. And more importantly, global diversification offers scant protection from market crashes when correlations become indistinguishable such as during the financial crisis of 2008-2009.

However geographic diversification still can protect portfolios against radical underperformance in a single geographic equity market.

Concentrated fund portfolios

Another method gaining popularity is aiming at achieving higher returns by investing in funds holding the least risky stocks. This can flip-side the managerial idea that holding too much in a given stock or market sector within a fund increases risk.

An average equity fund contains 100 or more different companies. Managers hedge their bets by diversifying among sectors. Alternatively some actively managed funds target their stock portfolio to aim at capitalizing only on stronger individual performances among fewer, more highly capitalized stocks as opposed to many.

The advantages of diversification, albeit reduced diversification, still remains among those stocks held therein and can play a role in a diversified fund portfolio. Some fund managers outperform by overweighting stocks and/or stocks within sectors that perform well. These managers prefer fewer individual stocks based on the stocks' own merits to outperform the market over the long term.

With a more concentrated fund, the fund manager needs greater skill to pick fewer excellent winners as he or she is placing the onus of performance on fewer stocks within the fund's portfolio. Thereby the disciplined role of the fund manager imparts to and increases the potential success of the fund's performance.

An advisor can identify equity funds concentrating on fewer excellent stocks with managers experiencing solid long-term track records while doing so.