How to Manage Risk in Today's Market
If there’s one thing you can say about investment in 2017 so far, it's that we’re in uncharted territory.
That’s not only because we have a president who came to Washington with little political experience, though with a supposed wealth of business wisdom. It’s also about a ticking clock for the investment climate. In the financial world, the bull market for U.S. stocks will be eight years old in March 2017. Only one other bull market has run longer, the one that ran more than 12 years, from 1987 to 2000.
Meanwhile, the decades-long bull market for bonds, fueled by record-low interest rates, seems poised to shift into reverse. All in all, this is a much different environment than the current generation of investors has ever seen.
For investors, that means risk is running about as high as it’s been in many years. What can you do now to help manage the inherent risks prevalent in financial markets at the moment? Here are a few tips.
Diversify among different asset classes
U.S. stocks have reached record levels riding a wave of investor emotion. Markets have been exuberant since the election of President Trump in November. But just as exuberance has pushed stock values higher, a change in that mood can quickly create the same dynamic on the way down.
Diversification among different stock investments, a traditional hedge, may not offer a lot of protection this time in the event of a downturn. As a case in point, BlackRock analyzed the performance of different stock categories relative to each other during the 2007-2009 market downturn. They found high correlations among large company stocks, small company stocks and international stocks during the collapse. In other words, when large-cap stocks declined in that bear market, they took small-cap and international stocks down too.
It’s important to diversify your investments beyond stocks, with adequate holdings in bonds and cash that are suitable for your risk tolerance.
Look at alternative assets
The investment markets are broader than just stocks and bonds. There are many other vehicles for investment your money that offer different return opportunities, and diversify risk.
These alternative asset classes typically behave in a different way than stocks and bonds. That can help you cushion some of the blow from a sudden downturn in these markets.
What’s considered an alternative asset? This would include many “hard” or “tangible” assets such as gold, precious metals and commodities—investments you can actually hold in your hand. But you don’t have to buy gold or commodities in physical form—you can invest in many of these alternative assets more easily through exchange-traded funds (ETFs).
Alternatives also include different strategies for managing wide swings in the stock market (e.g. long/short or market neutral strategies) or changes in the interest rate environment (e.g., duration management). Many of these strategies are also offered to investors through mutual funds or ETFs.
A strong rise in the stock market can cause your portfolio to tilt too far toward one investment or asset class. Such a shift may expose you to more risk that you may be willing to tolerate.
That’s why rebalancing is important. It’s like hitting a reset button for your portfolio, so you return your asset allocation to a mix with which you’re more comfortable.
But regular rebalancing also helps you adhere to one of basic principles of investing—buy low and sell high. When you rebalance, you take profits from investments that have performed well (selling high) and invest them in others that haven’t surged by as much (buying low).
It may seem counterintuitive to sell your winners and buy your losers. But remember, you’re not selling all of your winners—only a portion that has performed well for you.
As for your “losers”, you should recall the reason why you selected these investments in the first place. You didn’t think they were losers when you chose them and it’s likely they aren’t losers now—they’re just going through a short-term patch of rough performance.
Tune out short-term market noise
President Trump’s arrival in the White House has raised both passion and rancor among American citizens. The fever-pitch of emotions is also flooding the airwaves—from traditional outlets such as TV and newspapers, to social media platforms like Facebook and Twitter.
It’s natural for the investment markets to take cues from the media. But these reactions are not only emotional, they’re also short term.
Investors who are planning for the long term need to be cool, calm and collected when stories from the daily news filter into the financial markets. Tuning out the short-term noise can prevent you from making irrational investment decisions that can cost you down the road.
Even though headlines may change from day to day, your investment goals do not. Your investment strategy should be built around what those goals are, not what the media reports.
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