Suddenly, the bears were back on Wall Street. And so were the market pros who claimed the old tools — buy and hold, diversification — don't work anymore. The volatility and uncertainty left investors worrying, yet again, about what to do now.
Don’t panic, for starters. Don’t make major changes to your investments. Instead, experts say, now is a good time to check if your investment portfolio needs tweaking. Maybe the market’s spring downdraft means your stock holdings have dropped below what your long-term plan calls for.
“With the recent pullback, some folks might find themselves to be a little underweight” in stocks, says Joanna Bewick, co-manager of the Fidelity Strategic Income Fund (FSICX). “If you’ve strayed from that plan, you might take the opportunity to move back to that target.”
That might mean selling bonds and buying stocks to return to your targeted mix, which might call for having, say, 50% or 60% of your portfolio in stocks. Rather than “buy and hold,” Bewick dubs this strategy “buy and monitor.”
“You keep your strategic plan,” she says. “But you find opportunities to rebalance your portfolio back to your strategic target.”
John Leis, a personal finance vice president at American Century Investments, calls these “tactical adjustments,” noting his company would “in no way advise our clients to abandon their long-term investment strategies. There’s pretty strong evidence that a diversified portfolio and sticking to your plan clearly worked in 2009 and 2010.”
Getting ready for the next bear
A look at the market so far in 2011 shows just how volatile stocks remain after the collapse of 2008 and rebound of 2009 and 2010 (see chart). Remember, too, that bear markets are a fact of life. There have been 15 since 1929, the average lasting 19 months and taking the S&P 500 (SPX) down a stunning 40%, according to S&P Equity Research.
Most veteran market watchers don’t foresee a bear market lurking around the corner. They also don’t believe current conditions, uncertain as they are, require investors to jettison time-tested strategies in favor of brand new approaches.
“I don’t think from an investing standpoint things have changed fundamentally,” says David McPherson, a financial planner and principal at Four Ponds Financial Planning in Falmouth, Mass. McPherson and other experts say it still pays to be prepared for when the market goes up … or down. “You build your asset allocation with the assumption there are going to be some rough spots,” he says.
That means going back to the basics — developing a plan to meet your goals; assessing how much risk you can tolerate; diversifying broadly, and, of course, rebalancing.
So whether you’re a market newbie or a grizzled veteran, review these strategies now to make sure your portfolio can ride out a nasty downturn. You’ll have the added comfort of knowing your investment portfolio is aligned with your long-term goals.
Step 1: Risk you can live with
You may have already thought about your general tolerance for risk, but nothing puts a theoretical assessment to the test like watching your portfolio nosedive 30% or 40% in a matter of months. “You have to think very carefully about your risk tolerance and your risk horizon,” Bewick says.
By risk tolerance, Bewick means not just your appetite for risk (what you think you can live with in a down market) but your emotional tolerance for risk (what you can actually live with). If you’re losing sleep when your stock investments fall 3% in a week, your risk tolerance may not be as high as you think.
You can define your risk horizon by looking at when you’ll need to tap the money you’re investing given your financial situation. Whether you're 25 or 65, you should have an emergency fund equal to at least six months’ living expenses invested safely in cash. But what about money you want to use for a down payment on a house in five years? Should that be invested in cash, or a bit more aggressively, in a short-term bond fund or a blue-chip, dividend-paying stock fund, for example? It depends on your risk tolerance and time horizon, viewed as part of your overall plan.
The same goes for your retirement savings, though here is where being too risk-averse can hurt. If you invest too conservatively over the long haul, you run the risk of not amassing enough to carry you through retirement. Even if you already have enough to retire on, you need to ensure parts of your portfolio are growing fast enough to keep up with inflation.
An old investing rule of thumb says if you subtract your age from 100 you’ll have a rough idea of what percentage of your portfolio should be in stocks. In general, a 40-year-old investor would keep 60% of his or her portfolio in stocks.
“That’s still a good rule of thumb,” says Ned Sundermann, president of Sundermann Capital Management, an investment advisory firm outside Denver. But he adds: “It needs to be adjusted for situations. And this is one of those times.”
The debt crisis in Europe and worries about a global economic slowdown have pushed yields on short-term Treasury bills near zero. The yield on the two-year Treasury, meanwhile, is below 1%.
“It’s mathematically impossible for rates on cash and bonds to go much lower,” says Sundermann, noting today’s low-rate environment and the threat of inflation down the road are arguments for favoring stocks.
Sundermann recently advised a 45-year-old client to put 70% to 75% of his investments in stocks and 20% to 25% in bonds and other fixed-income investments. The latter includes preferred stock, which provides a fixed dividend payment that takes priority over dividends to holders of common stock, and floating rate bonds, whose rates vary depending on rates in the market.
“The bottom line is you must have exposure to assets that rise in value and have rising returns to survive in a period of rising costs,” says Sundermann.
Step 2: Diversify, diversify, diversify
For decades, most investors used the simplest form of diversification, investing in U.S. stocks, bonds and cash, with some additional assets tied up in their homes.
Diversification can help reduce risk and volatility in a portfolio. Different asset classes perform differently in different situations. And today it’s much easier to diversify than it used to be thanks to technology and the growth of new products. There’s a mutual fund or an ETF for almost any strategy.
Remember, too, that no two bear markets are identical. In 1987, when the Dow (.DJIA) crashed in October, international stocks returned 25% that year, as measured by the EAFE International Stock Index, a benchmark of non-U.S. stock markets. But international stocks were big losers in the bear markets of 1990 and 2001, tumbling 23% and 21%, respectively.
The reality in today’s markets, though, is that more and more supposedly different types of assets seem to move in tandem, as they did in 2008. That means you’ll need to sharpen your strategy to achieve true diversification. There’s no perfect solution, though.
The bottom line: Cast your net widely. Own stocks, bonds and short-term investments like CDs and money-market funds that typically don’t move with stocks, giving your portfolio a layer of risk reduction.
But don’t stop there. Your stock holdings, for example, should include companies of varying sizes in a wide array of industries, and should reflect different investment styles to include growth stocks and value stocks. There’s also geographic diversity: include companies from countries in Europe, Asia and emerging markets.
Replicate that strategy for bonds. Your fixed-income holdings should include varying maturities as well as issuers, such as governments and corporations as well as possibly tax-free municipal bonds. Look overseas, too, experts say. Mutual funds that invest in stocks or bonds can provide instant diversity in those two areas.
You can go further. True diversification means including asset classes that are negatively correlated to the U.S. stock market (when U.S stocks zig, they zag), and simply uncorrelated — in other words there’s little or no relationship to broad market performance.
“We are looking for asset classes and investments that are as lowly correlated as possible,” Fidelity’s Bewick says. She points to “inflation-fighting” assets such as mutual funds and ETFs that hold real estate investment trusts, agricultural commodities such as cotton and coffee, precious metals, and floating-rate debt.
Step 3: Monitor and rebalance
After you build (or adjust) your portfolio, you’ll need to review it at least annually, if not quarterly or monthly, to ensure the mix is where you want it. “The people who bury their heads in the sand will experience the worst losses,” says Brenda Wenning of Wenning Investments, an investment management firm in Newton, Mass.
Selling winners and buying losers is a tough discipline to implement, but in the end it is how money is made. If stocks or stock funds have soared so they make up too much of your portfolio, it’s time to sell some of those assets; if they’ve fallen to an unacceptably low slice of your holdings, it’s time to buy.
It’s also OK to alter your targeted asset allocation a tad to capitalize on market trends — like a 20% decline in the stock market that puts stocks at bargain-basement levels, or an expected increase in overall inflation.
“Have your asset allocation and maybe tweak it,” says James Swanson, chief investment strategist at MFS Investment Management in Boston. Pointing to low interest rates and robust corporate profits, Swanson adds: “You’ve got an unusual combination of factors that are tilting the historic context more in favor of stocks than bonds” right now.
How much should you change your targeted allocation mix if you spot a longer-term market opportunity? “Maybe you take your asset allocation plan and tweak it five to 10 percentage points around that,” Swanson says.
Above all, don’t panic and do something you’ll later regret. Think of the investors who bailed out of stocks near the market bottom in March 2009. Remember, long-term investing is a marathon, not a sprint. It requires careful planning, and prudent adjustments, every step of the way.
THE BEAR-PROOF PORTFOLIO CHECKLIST
- Inoculate your portfolio against a
bear market now, rather than waiting
for stocks to tumble 20%
- Do a gut check to determine how
much risk you can tolerate
- Next, examine how much risk you
can actually afford to take based on
your age, investment horizon and
financial situation
- Craft a portfolio that meshes with
your overall risk profile
- Diversify your portfolio to help meet
your goals
- In addition to different asset classes
and sectors, don’t forget overseas
investments
- Review your portfolio annually, if
not quarterly, and rebalance as
needed
- Consider tweaking your investment mix if you see a longer-term market
opportunity
- Check with a financial adviser if you
need help
- Stick to your plan through bull and
bear markets, and avoid panic-driven decisions you'll regret later
July 8, 2011