The media is reporting on the inverted yield curves, repo market madness with the banks, student loan debt defaults and plenty of other areas of financial doom and gloom. With all the spooky talk of a recession let’s look at 5 ways you can lessen the risk in your portfolio. Even without the media spewing their negativity, if you’re within three to five years away from retiring it’s a good idea to take a hard look at your portfolio to see if you need to pull back on the risk you’re taking. Everyone’s situation is different. These are just general ideas to think about.
Here are 5 ways to lessen the risk of your portfolio:
1) Evaluate just how much risk you’re currently really taking
Are you diversified? Individual stocks and mutual funds risk can be measured by several different numbers, but the simplest way is to look at the Beta for your holdings. The key to lowering your risk in your portfolio is lowering the beta. This can be done by diversifying your holdings.
Beta measures the amount of volatility (systematic risk) that your holdings will have against its benchmark. For example, the S&P 500 index has a beta of 1.00 so if you’re comparing a US large cap fund to the S&P 500 and that large cap fund has a beta of 1.10, then in theory your fund is 10% more aggressive than the S&P 500. On the flip side, if your fund has a .75 beta, then you are taking quite a bit less risk than the S&P 500. Ideally, you’d like to find stocks and mutual funds that take less risk than the S&P 500 but outperform it.
Keep in mind there are all sorts of asset classes when it comes to investing and it can be very confusing as to what you’re holding. For example, when I was a full-service financial advisor, it wasn’t uncommon to look at a couple’s holdings to find they held eight different mutual funds but all eight were large cap growth funds that held the same stocks. Just because you have eight funds by eight different names doesn’t always mean you’re diversified.
Pulling down your beta is best done by diversifying your holdings. Which assets can help do that? See #2.
2) Non-Correlating Assets
Non-Correlating assets are assets that tend to move on their own regardless of how the stock market is doing. It can be areas like precious metals (Gold, Silver, etc.), real estate, bonds and currencies.
Precious metals, such as gold, tend to see price increases during times of panic and fear in the stock market. Real Estate will move on its own based on supply and demand. Bonds are interest rate sensitive and tend to do well when interest rates are falling. Currencies will tend to move based on the financial health of the country issuing the currency.
Typically in a choppy or negative overall stock market, especially when interest rates are falling (like they are today as I write this), bonds can be a great way to lower the overall risk (and your beta) of your portfolio. Real estate is another great way to diversify.
As a reminder, diversifying and lowering the risk of your portfolio doesn’t always mean that you’re moving from small-cap growth to large cap growth. If your goal is to reduce risk, adding some bonds, precious metals or real estate to your portfolio can really help.
3) Go to Cash
Another way to reduce the risk of your portfolio is to hold a higher cash position. Now obviously holding more cash in your portfolio’s money market account isn’t going to yield you much of a return but it is a safe position to be if you are concerned about the overall market.
There is no crystal ball that will tell us how the market is going to perform. Knowing how much to pull to cash is based on your comfort level. Now, there is a big difference in going from 5% to 20% cash and trying to time the market. Tread lightly so as not to lose capital unnecessarily. Also, the more you sell and covert to cash, beware, there may be tax consequences.
If you are concerned, having a little more cash on hand in your portfolio will lower your overall risk.
4) Preferred Stocks
Preferred stocks are stocks that pay a holder a fixed dividend. They tend to pay a higher dividend than a common stock as well as they have a “higher claim” than common-stock holders. This means the payments to Preferred-stock holders takes higher priority over that of common-stock dividends. Simplified, it’s like a cross between a common stock and a bond. Preferred stocks look like a bond because of their higher dividends but also look like a common stock because the price of the stock can rise and fall. However, the price of a preferred stock tends to move less than their common stock counterparts. The dividends that preferred stocks pay either get paid out monthly or quarterly.
5) Inverse ETF’s
Now this one can be a bit tricky. I want to educate you on the possibilities, but Inverse ETF’s are more for the experienced investor. Inverse ETF’s are exchange-traded funds that “short” a certain index or benchmark. Simplified, it’s a bet that a certain index is going to fall. For example, if you buy an inverse ETF S&P 500 and the S&P 500 loses 1% then your inverse S&P 500 ETF would gain 1%. As the corresponding index falls, you make money. The risky part is if you guess wrong and the index goes up 10% then your inverse ETF just lost 10%. These can be tricky and should be used with caution but in the right environment such as a stock market that is having a prolonged down turn, they could help offset losses.
These techniques are not for everyone but they are commonly used to reduce the risks of a portfolio. Everyone’s portfolio is different so what might work for you may not work for the next person.
Lowering the risk of your portfolio is fairly easy. The right time to do it is the difficult part. You want to ride the good times of the market but be prepared and have a plan when the bad times come. What is your plan?
If you need help with lessening the risk of your portfolio, I’m here for you. I’m an advice-only advisor who does not sell any products. I often review and give advice on portfolios to folks all across the country. You can find me here: http://livefreeretirementadvisor.com/ask-eric/
Live free my friends,