The robust US economy has convinced many investors that they can keep riding the nine-and-a-half-year bull market in stocks even higher. But overconfidence—or neglect—could be dangerous, possibly leaving you vulnerable to losing years of accumulated gains. That’s because there are plenty of factors that could trigger a recession and bear market by late 2019 or 2020, including a sudden surge in inflation and interest rates.
That doesn’t mean it’s wise to try to “time the market” by dumping stocks entirely. Instead, many advisers say, it’s a good time to reduce risk by scaling back the stock portion of your portfolio to more moderate levels. But how do you accomplish that?
Answer: Baby steps.
Adopt simple strategies that ease your portfolio back to a mix of stocks, bonds and cash that you feel comfortable holding even in rough times. Important: If you haven’t established long-term target allocations for different types of assets, a reasonable starting point is 60% stocks and 40% bonds and cash. (The amount of cash will depend on your risk tolerance and your possible need to draw on your portfolio for income, perhaps in an emergency.) Your optimal mix may be more conservative or aggressive depending on how long it will be before you need the money, your income needs and risk tolerance.
To help you, Bottom Line Personal spoke with five leading financial advisers about the strategies they use to reduce their clients’ stock exposure so that they’ll be better protected when bad times do roll around…
Stop making new purchases of stocks (including stock funds). If you regularly contribute to your portfolio and your current asset mix isn’t very far out of balance, you can bring it in line by simply redirecting new money. Instead of buying more stocks, put the money into bonds—preferably in the form of a relatively short-term, investment-grade bond fund that is not badly hurt by rising interest rates—or leave it in cash. You also can stop automatic reinvestment of dividends thrown off by stocks you own. This incremental strategy is particularly useful for taxable accounts in which selling stocks too aggressively could generate big capital gains taxes.
Peter Lazaroff, CFA, CFP, is co-chief investment officer at Plancorp, an investment-advisory firm that manages $4 billion, St. Louis. PeterLazaroff.com
Dollar-cost average away from stocks. Many people are used to “dollar-cost averaging” their way into stocks—that is, adding to a position with a fixed amount of money every month so that they are buying more shares when prices are low and buying fewer shares when prices are high. Over time, this can result in a lower average buying price—a good thing. But when you are already too heavily invested in stocks, you can choose to do the reverse—sell a fixed value of the stocks each month. That way you are still taking advantage of the market’s remaining gains and possibly locking in more and more of your profits—but reducing your exposure in case the market starts retreating. This is a more aggressive approach than the one above, and you can choose to mix the two approaches to achieve your target allocations more quickly.
What to do: Determine the dollar amount of stock that you need to sell to reduce your stock holdings back to your long-term target allocations. Divide the amount by 12. Over the following year, each month on a given day, sell that dollar value of stock regardless of market conditions.
Caveat: If selling from a taxable account, you might generate taxable capital gains, so take this into account and weigh it against the value of reducing your portfolio’s risk.
Scott B. Tiras, CPA, CFP, is president of Tiras Wealth Management, a financial-advisory practice with $2.2 billion in assets under management, Houston. TirasWealth.com
Sell your “highest-risk” assets first. This approach is for investors who have built up a relatively aggressive portfolio but who want to reduce risk now. Paring back your riskiest stocks leads to a stronger emphasis on stocks of high-quality companies with strong balance sheets. These tend to be less damaged by a market downturn.
Three criteria to identify the “highest-risk” assets in your portfolio…
- Pinpoint your most overvalued stocks. Look at the current price-to-earnings ratio (P/E) of all your stocks compared with their long-term historical P/Es, which you can find at Morningstar.com, and jettison those that are most out of whack.
- Determine which stocks are in historically volatile sectors, such as biotech and small-cap growth stocks.
- Zero in on speculative investments that no longer fit into your long-term plan…or that just keep you up at night, such as the social-networking service Twitter or electric-car maker Tesla.
Mark Germain, CFP, is founder and CEO of Beacon Wealth Management, which has more than $250 million in assets under management, Hackensack, New Jersey. BWMllc.com
Once you reach your target asset allocation, rebalance your portfolio using the method that institutional investors use. Various financial institutions and pension funds typically use “thresholds” as signals of when to rebalance rather than limiting the practice to once a year. A typical threshold is whenever assets in a given class move away from their target allocations by five percentage points or more. Threshold rebalancing requires more portfolio oversight and can increase your trading costs and capital gains taxes, but it has two advantages. In rising stock markets, it locks in and protects your profits. In falling markets, it forces you to accumulate more shares of stocks at lower prices so that you don’t have to guess when a bear market has bottomed to get back in.
Jonathan D. Pond is president of Jonathan D. Pond, LLC, an investment-advisory firm with $280 million in assets under management, Newton, Massachusetts. JonathanPond.com
Play with “house money.” Investors often become so enamored of a particular stock that they have a hard time trimming back that holding even if the stock seems grossly overvalued and at risk for big losses. This can be problematic because even if you reduce the overall stock exposure in your portfolio, you’re still courting outsized risk with this holding. Wise solution: Sell enough shares in this stock to generate the amount of cash that you originally invested in the stock. That way, even if the stock plunges, you can’t end up losing more than you invested, and you could achieve further gains with the money still invested. For example, say you invested $10,000 in Facebook three years ago. Your shares are worth about $17,500 today. You take out the original principal ($10,000) but keep the rest ($7,500) invested.
Rick Miller, PhD, CFP, is CEO of Sensible Financial, a financial-planning and investment-advisory firm with more than $450 million under management, Waltham, Massachusetts. SensibleFinancial.com