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The first half of 2021 has been very different from the volatile first six months of 2020. At this point, the Standard & Poor’s 500 Index has returned 15% in the first half of this year, healthy growth for virtually any full year.
Still, with the possibility of inflation stalling the gears of growth – fueled by trillions of dollars in past and potentially future stimulus spending – there are concerns about how investors should adjust their portfolios for the second half of 2021. .
Now is the time to focus on managing risk by looking at what many investors seem to ignore: diversification. Certainly, there is reason to believe that diversified portfolios can do well, even with the uncertainty of inflation and rising interest rates.
Granted, there is a downside to diversification, and that is that if stocks continue to post record gains, you will likely be making less money. However, some exposure to a mix of assets such as non-US dollar denominated stocks, value stocks, corporate bonds, and foreign bonds could be very beneficial if something goes wrong.
Despite the historic run of the stock market over the past two years, I often remind clients that large-cap US stocks don’t always produce the best returns. For example, for the 15-year period from 2000 to 2014, bonds actually outperformed US large-cap stocks.
Hardly anyone I speak with thinks this could be true, although most have actually experienced it. Recency bias, or the behavioral trait of extrapolating what happened in the short term as difficult as it will happen in perpetuity, is common when it comes to investing.
As we move into the second half of the year, here are five ways to make sure your portfolio is diversified, positioning it for growth while protecting against a possible downturn:
1. Invest in underperforming market segments: Consider investing fresh money in stocks from emerging markets, developed foreign countries, and value US stocks such as energy and financial services companies. I wouldn’t recommend topping up on these investments or aggressively selling the top performing stocks you already own. Instead, just don’t overlook underperforming areas of the market by using fresh money to invest in those areas to help balance your portfolio.
2. Rebalance your portfolio: The S&P 500 returned around 40% in the 12 months ending June 30. Anyone using a traditional target allocation between stocks and bonds should consider adjusting their portfolio so that they have the right proportion of assets that match their financial plan.
This is a good strategy to use if you don’t have any cash on hand in the coming months to help rebalance with new investments. For example, by reducing a portfolio to 70% to 75% stocks to its original target of 60%, the risk is reduced.
This strategy may sacrifice some return on your investment, but rebalancing attempts to implement a “buy low, sell high” strategy and protect against a possible future bear market.
3. Stick to bonds and limit your exposure to US Treasuries: Despite low bond yields across the United States, bonds still offer diversification benefits. Anyone who thinks they cannot anticipate the market will benefit from this strategy, because if something goes wrong, bonds have historically offered better security than stocks.
While this data may have escaped the radar, US long government bonds returned 6.5% and US core bonds 1.8% in the second quarter of the year as inflation fears subsided. are attenuated. Long-term US government bonds are very sensitive to interest rates and will likely perform poorly if inflation accelerates.
For those who are more concerned about inflation, focusing on corporate bonds with varying degrees of credit risk is a good option.
For investors with equity portfolios, I have two recommendations:
4. Compare your sector allocation to the S&P 500: Another way to manage risk within a portfolio is to take a “market neutral” approach when it comes to building a portfolio. Investors who own individual stocks can compare their overall equity portfolio weighting by sector to the S&P 500 and adjust it to ensure that it is similar to the index.
Without such a strategy, investors often end up chasing a favorite sector or a few high-profile stocks, which increases risk. This usually results in an imbalance between sectors relative to a well-diversified index such as the S&P 500.
By failing to use a market neutral strategy, investors could easily be overweighted in technology, healthcare and communications services, as these sectors have performed particularly well in recent times. As a result, many investors are underweight in less popular areas such as energy, financials and industrials due to their poor performance.
5. Reduce the stocks that appreciated significantly: Many investors are looking for extra cash to pay for travel and other items now that the economy is reopening. Taking gains on the best performing stocks is a great strategy to help reduce risk. Often, investors want to limit the amount of taxes paid on withdrawals. While this may be optimal under certain conditions, in most cases it makes more sense to focus on investment risk, not taxes.
By trying to minimize the tax bill every time a stock is sold, an investor could potentially end up with a concentrated portfolio of a handful of stocks. If the market continues to rise, keeping your top players will probably be a great strategy.
But if market trends change, it could seriously damage a portfolio, as stocks with smaller gains or losses that were sold would likely have held up better during a market reversal. When a pullout is needed, whittling away the winners is a risk management strategy that helps you stay diversified.
As always, no one knows where the market will go over the next few months. It could continue to climb and keep investors smiling, or not.
Regardless of what happens with inflation, Covid-19 variants, or an unpredictable market event, risk management is crucial when it comes to seeking or maintaining financial independence.
– By Jeff Harrell, Director of Portfolio Management at Brightworth