How to Design a Less Volatile Stocks Portfolio


Designing a less volatile equities portfolio requires an approach that blends macroeconomic insights with strategic cash flow management.
The crux of this approach involves focusing on stable cash flow streams and incorporating macroeconomic overlays to better control the short-term volatility.
This way, an equities portfolio can reduce downside exposure while maintaining resilience across varying market environments.
We outline an approach to building a portfolio that withstands market volatility while providing steady returns over the long term.
Key Takeaways – How to Design a Less Volatile Stocks Portfolio
- Over the short-run, macro factors influence stock prices more than the earnings/cash flow produced by the company.
- (Over the long-run, the cash flow matters more than the macro cycles.)
- Can you design a portfolio that isolates the cash flow from the pricing to create a more predictable return stream?
- If you determine what the underlying drivers of the volatility are (e.g., changes in discount rates, risk premiums, and changes in discounted growth and inflation), you can help create such a portfolio by hedging against unfavorable changes in these variables.
- This stability becomes important in a world where there are a) low yields and/or b) higher inflation volatility relative to growth volatility – i.e., where bonds no longer serve as reliable income generators or counterweights to stock risk.
The Need for a Cash Flow-Oriented Equities Portfolio
Addressing Low Bond Yields
Historically, bonds provided a stable return source, balancing equity risk and being a fundamentally different type of exposure.
However, with bond yields sometimes providing inadequate return, the reliability of bonds as a stable return varies.
And this is especially true with cash, which often has had long durations where it yields zero or simply below the rate of inflation.
Consequently, the focus then shifts to constructing equity portfolios that can provide a steady cash flow stream akin to bonds, albeit at a higher level due to the equity risk premium.
The goal is to create a portfolio that could mimic bond-like stability while leveraging equities’ long-term growth potential.
Importance of Stable Cash Flow Streams
A key component in achieving portfolio resilience is generating a stable cash flow stream.
By separating the cash flow stream from price fluctuations, traders/investors can manage both the income/cash flow and price components independently – e.g., focusing on the sustainability of cash flows.
This method offers better resilience to market downturns, allowing the portfolio to better benefit from the power of compounding over time.
When structured correctly, these consistent cash flows can ultimately deliver higher returns due to the effects of reinvestment and compounding.
Portfolio Construction: Steps to Building Stability and Resilience
Designing a stable equities portfolio involves three primary steps:
- identifying reliable compounders
- assessing valuation, and
- incorporating a macro overlay to manage external risks
Step 1: Selecting Reliable Compounders
The foundation of a resilient portfolio lies in selecting companies that act as “reliable compounders.”
This subset you might think of as approximately the top 30-50% of the market – i.e., however you might want to draw the line between quality and having sufficient diversification.
They’re characterized by stable earnings, consistent revenue growth, and strong balance sheets. Eseentially good stores of value.
Reliable compounders are typically companies that have demonstrated their ability to endure economic downturns while maintaining positive cash flow.
The Dividend Aristocrats would be one example of where to look, but also stock screeners could work as well.
Criteria for Reliable Compounders
Reliable compounders generally have:
- Stable earnings – Companies with earnings stability are better able to handle less-than-ideal economic conditions.
- Consistent revenue growth – Predictable revenue streams enhance the likelihood of consistent cash flows.
- Strong balance sheets – Firms with low debt and ample liquidity are less vulnerable to interest rate increases and economic slowdowns.
By filtering out the bottom 50-70% of the market, which consists of companies with less consistent cash flows or higher volatility, traders/investors can build a portfolio of high-quality equities likely to endure and grow over time.
Companies you might expect to be part of the “quality” contingent might be more concentrated toward sectors like consumer staples and utilities simply because they sell stuff that people need to physically live.
So, they will tend to have more stable earnings and revenues, and the balance sheet situation (good assets with comparatively low debt and liabilities) depends on the specific companies.
Step 2: Valuation Assessment
The second step involves conducting a classic valuation assessment within the pool of reliable compounders.
This step focuses on identifying companies with high free cash flow and favorable earnings relative to their prices.
These undervalued stocks can boost the portfolio’s returns and add resilience by providing potential upside during economic recoveries.
Adding a Layer of Resilience Through Valuation
Incorporating undervalued stocks with strong fundamentals provides:
- Potential for upside capture – The portfolio gains when these undervalued stocks rebound in price.
- Downside protection – By selecting stocks with favorable cash flow projections, the portfolio is buffered against significant declines during downturns.
With this two-tiered approach you might expect the portfolio to capture roughly 100% of the stock market’s upside while experiencing only about 65%-70% of the downside.
Step 3: Macro Overlay for Short-Term Risk Management
Despite security selection and valuation assessments, portfolios remain vulnerable to broader macroeconomic shifts.
If stocks fall they all tend to fall together.
So, the third step addresses this by implementing a macro overlay to hedge against short-term risks associated with interest rate changes, discount rates (a function of interest rates), and risk premiums.
Other important variables include changes in discounted growth and inflation.
The macro overlay is important in reducing volatility that stems from macroeconomic events rather than company fundamentals.
Targeted Down Market Protection
Macro overlays serve as targeted protection in down markets, where equity markets often experience synchronized declines.
Rather than attempting to hedge by shorting individual stocks, which can be inefficient and costly (e.g., shorting and borrowing costs), the overlay strategy uses liquid markets that respond to macroeconomic conditions, such as interest rate hedges or credit spreads.
And doing it in a way that isn’t negative carry (i.e., paying to have hedges where the cost is in excess of the protection it provides).
For example, the trader could measure the duration of the portfolio and use interest rate derivatives or bond futures to hedge out the interest rate risk.
So, if the portfolio were to fall because rates increased by more than whatever is discounted into markets, the fall in stocks (due to that influence) is offset by the rise in the value of their hedge.
For the risk premium factor, this is where shorting credit spreads in the appropriate amount can be helpful.
This, in turn, helps to better isolate the influence of the cash flow from the stocks themselves – i.e., what the company is earning.
Brokers are also increasingly offering growth and inflation derivatives.
So, overall, using macro overlays allows the portfolio to:
- Neutralize short-term market volatility – The overlay can hedge against risks like interest rate increases or spikes in risk premiums.
- Improve transaction efficiency – Targeting macro sources of volatility is typically more efficient than hedging individual stocks.
- Stabilize long-term returns – Addressing macro-level risks the portfolio achieves greater consistency in returns over time.
Extending Resilience Through Diversification
Geographic Diversification
Incorporating global equities diversifies the portfolio across different economic cycles and reduces the impact of region-specific risks.
Traders/investors can manage exposure to economic trends and policies that vary by region.
This approach allows market participants to take advantage of the strengths of various markets while minimizing exposure to country-level economic/market risks.
Sector Diversification
And while the portfolio may be concentrated in stable companies, sector diversification adds another layer of protection.
Different sectors respond uniquely (but not totally uniquely) to economic conditions, so spreading investments across sectors such as technology, healthcare, consumer goods, and utilities provides balance.
As mentioned, consumer goods and utilities, as well as some healthcare sub-sectors with stable earnings, tend to be more resilient during recessions/market falls.
On the other hand, technology and industrials – due to the duration of their cash flows or their discretionary nature – often excel during periods of economic expansion but perform poorly in down markets.
Building Liquidity into the Portfolio
Maintaining liquidity is important, as it allows traders to reposition as necessary.
A portfolio balanced between liquid and income-generating assets – such as dividend-paying stocks – ensures that there’s sufficient liquidity to take advantage of buying opportunities during downturns or adjust the portfolio in response to economic shifts.
Income-Generating Assets
Investing in high cash flow or dividend-paying companies provides ongoing income, which can be reinvested or used to adjust the portfolio during economic shocks.
Dividends act as a buffer during periods of price decline, offering returns to investors even when stock prices are under pressure.
Time Horizon Considerations
The impact of cash flows versus price changes varies significantly depending on the time horizon.
Short-Term
In the short term, equity returns are often driven by price fluctuations, which reflect immediate market sentiment and macroeconomic changes.
For example, let’s say a company is trading at a 15x P/E ratio.
Evaluated quarterly, it’s earning 1/60th of the company’s value per quarter.
That’s less than 2%. It’s not much.
If you go up to a 25x P/E ratio, then it’s just 1%.
Of course, it depends on the growth of the company.
So, in the short-run, the price dominates the return stream.
Long-Term
However, over a long-term horizon, the compounding effect of cash flows becomes the dominant driver of returns, reducing the impact of price volatility.
If you go out 10 years, for example, then:
- a 15x P/E company – even assuming no growth – has made ~67% of its value in earnings and
- a 25x P/E company (which for purposes of this exercise you might reject on value considerations unless you’re getting commensurate growth) has earned 40%
Short-Term vs. Long-Term Cash Flow Dynamics
So, to sum up:
- Short-Term – Quarterly returns are often dictated by price, which is highly sensitive to market conditions and investor sentiment.
- Long-Term – Over a ten-year horizon, cash flow stability takes precedence, creating a duration that reflects the long-term performance of the underlying businesses rather than short-term price fluctuations.
So, by aligning the portfolio’s time horizon with the compounding benefits of cash flow, the equities portfolio becomes less sensitive to short-term market shocks and more resilient over time.
Systematizing the Process
If/when possible, consider systematizing the process.
A systematic approach to this involves continual reassessment of security selection and overlays, and helps you make sure the portfolio remains aligned with the stability goal.
Stock screeners for security selection can be a good place to start.
FAQs – How to Design a Less Volatile Stocks Portfolio
Is it a good idea to sell some of my stock during volatile markets?
Selling can make sense if you’re reducing concentration risk or trimming in late-cycle or overvalued conditions to raise cash for future opportunities.
But be cautious. Selling after markets fall is often a costly mistake, since lower prices usually mean you’re buying more future earnings per dollar invested.
Why is diversification important?
Diversification isn’t just about holding many assets or straying from your core skill set or goals – it’s about owning assets, asset classes, and return streams that behave differently across economic environments.
Over a lifetime, your favorite asset class will likely fall 50–80% or more. And because all known information is already priced in, you won’t know in advance which asset will suffer.
What you can know is that different assets perform well in different regimes (and you can be pretty sure that over the long run they’ll outperform cash).
- Stocks, for example, tend to do best when growth beats expectations and inflation is stable.
- Government bonds do best when growth and inflation disappoint.
- Commodities excel in inflationary booms (sometimes even driving the inflation).
- Cash preserves capital and does well in relative terms when money and credit tighten.
When spreading your capital across these dynamics, you’re not trying to predict the next winner; you’re building a portfolio that can adapt well to whatever comes.
This approach raises your chances of achieving a higher return per unit of risk and so that no single scenario (like a surprise inflation spike or growth shock) can ruin your financial trajectory.
Should I try to time the market or pick bargains during volatility?
Volatility can create opportunities. When prices disconnect from fundamentals, patient capital can step in and find value.
But it’s critical to approach this with humility. Markets are intensely competitive where you’re up against professionals with better information, faster data and calculation, better analysis, and more experience.
Trying to consistently outguess them is like challenging pro athletes at their own sport or playing games at a casino with the odds structurally stacked against you.
Why do professional traders/investors, pro athletes, and casinos tend to beat their opposition?
They effectively have a statistical edge over weaker players.
While it’s tempting to chase tactical “bargains,” amateur investors typically carry a negative statistical edge in the markets they participate in. That’s why the smarter long-term approach is to focus on broad diversification across asset classes and economic environments.
Diversification reduces reliance on any single forecast or trade, so your portfolio is resilient regardless of what the market does next (that’s beyond your control).
In short, seeking value is reasonable, but don’t build your strategy on market timing or overconfidence.
Let diversification, not tactical bets, be your main lever for improving return relative to risk.
For those trying to achieve alpha, it’s important to own and learn from your mistakes.
Falling into a psychological trap of: good trades = “knowledge/skill” and bad trades = “bad luck/things happened that I didn’t foresee” isn’t effective.
How much attention should I pay to daily market moves?
For long-term holders, very little. In that case, watching your portfolio daily is like steering a ship by watching every wave; it creates stress without improving outcomes.
What truly matters is your portfolio’s resilience over years, not its performance over days.
Consider this: a 6% annual return equates to just ~0.02% per day, yet daily swings in the stock market (for example) often exceed 1% – i.e., that’s 50 times greater than the signal you’re trying to capture.
In other words, the noise overwhelms the signal.
Most daily, weekly, and even quarterly fluctuations say more about sentiment and liquidity than long-term fundamentals.
Even annual results can be misleading in the context of a decades-long plan.
For long-term investors, success comes not from reacting to short-term volatility, but from staying invested and letting the compounding engine do its work.
The path to long-term returns is paved with short-term chaos; ignore it.
How can I stay grounded during market turbulence?
Start by anchoring to what actually matters: your personal goals.
- Ask yourself: what long-term return do I truly need to meet my objectives?
- How much volatility can I realistically handle without abandoning my plan?
- And most importantly, is my strategy aligned with the purpose my money is meant to serve – e.g., security, freedom, legacy?
These questions reframe markets from daily noise-producing mechanisms to serving real-life priorities.
They shift your focus from abstract metrics and unpredictable headlines to what you can control: your behavior, discipline, and alignment with long-term goals.
That perspective leads to better decision-making, greater peace of mind, and stronger financial outcomes over time.
Conclusion
Focusing on high-quality, stable cash flow companies and using valuation and macro overlays, a portfolio can reduce exposure to downside risks while capturing growth potential.
Geographic and sector diversification, combined with liquidity management and long-term compounding, further stabilize the portfolio.
Ultimately, this approach is designed to allow traders to deal with both short-term volatility and long-term economic shifts, so you have a more resilient and dependable equities portfolio.