A stock market downturn isn't happening right now, but that doesn't mean a bear market isn't coming.
If your equities, bonds and other investments aren't diversified, you aren't prepared.
According to a new study from financial services firm Edward Jones, 64% of investors are concerned about market volatility within the next year. However, 55% say they would not adjust their portfolios if the stock market declined more than 10%.
"It's encouraging to see that investors aren't making rash or emotional decisions when it comes to their investment portfolios," says Kate Warne, principal and investment strategist for Edward Jones. "It's important to remember that markets naturally peak and dip over time, fluctuating much more frequently than the U.S. economy. Having a well-diversified portfolio will work to hedge against market volatility, lessening the impact of inevitable corrections."
John Diehl, senior vice president of strategic markets at Hartford Funds notes that since the 2008-09 economic downturn, investors have reaped the benefits of a near-unabated bull market. This troubles Diehl, as he feels this run of good fortune has given investors a false sense of security and may be making them lose sight of the risk associated with their portfolio. That makes them the hot hand fallacy: Expecting future results to mimic past results. If investors expect this upward streak to continue and, in turn, go "all in" with their investments, they won't have the will to diversify their portfolios and shield themselves against downturns.
"Historical market data illustrates that market corrections are inevitable and unpredictable," Diehl says. "By focusing only on the near-term trends, investors could be leaving themselves vulnerable to larger losses, not just potentially enjoying larger gains."
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Even investors are starting to get the feeling that their portfolios are a bit out of balance. As the Edward Jones survey found, in the event of a market correction, one-third of Americans (33%) believe their retirement portfolio is not diversified enough to live comfortably in retirement. Millennials (37%), the group farthest from retirement, were just as worried about their ability to retire as Baby Boomers (35%) and Gen Xers (32%).
"It's understandable that those closest to retirement would be concerned about how a market correction will impact their ability to retire comfortably, but others are concerned as well," says Scott Thoma, principal and retirement strategist for Edward Jones. "Reviews are always important. But especially as investors approach their retirement, it's critical to review their investments to ensure they are appropriately balanced relative to their income needs and comfort with risk, as well as ensure they have enough cash to cover their near-term spending needs."
As Diehl says, it's about expecting the unexpected and building for the long term. Reaching your goals takes time and patience, but time brings a lot of ebbs and flows to the market. A diversified portfolio can minimize the damage, even if it sacrifices fast cash in the short term. Nigel Green, founder and chief executive of UK-based deVere Group, which advises clients on has more than $10 billion in investments, notes that diversifying your portfolio should be almost instinctual after the last economic collapse.
"No one asset class, sector or region wins all the time, therefore in order to mitigate risk and benefit from opportunities, investors need to spread their funds around," he says. "Markets work in cycles and when one asset class, sector or region is up, others are going down. The aim is to minimize exposure to one class, so that if that class is not performing well, the others are holding up the portfolio and keeping your investment objectives on track."
Paul Jacobs, chief investment officer of Palisades Hudson Financial Group in Scarsdale, N.Y., notes that the proper response to soaring U.S. stocks isn't to jump on the winners, but to go where the losses have been heaviest. He suggest investing about 15% of your equity portfolio in Europe, with exposure to both the U.K. and the rest of Western Europe. That's actually fairly light compared to Europe's share of global capitalization but that offers some protection amid its long-term economic struggles and political gridlock.
"There are many strong global companies based in Europe, so it still makes sense to have a significant stake in them," Jacobs says. "Companies like Nestle, Royal Dutch Shell, and GlaxoSmithKline are titans with worldwide operations."
He further recommends investing in large-cap European stocks through low-cost index funds such as the Vanguard European Stock Index Fund, but selling some of your losing investments to cut your tax bill. If you have some gains, you can used the losses to match them dollar for dollar. Even if you don't have gains, you can deduct up to $3,000 of capital losses per year.
Joe Correnti, senior vice president of brokerage product at Scottrade, notes that any jolt in the market provides a fine opportunity to look at your portfolio and sort out any imbalances. If, say, your portfolio is targeted for 60% equities and 40% bonds, a huge drop in equities could leave you with a whole lot of fixed income investments. If you want to get back to your target ratio, you can either rebalance your portfolio yourself or see if it rebalances on its own. Just don't take too much time with that decision.
"When owning equities, it's important for long-term investors to maintain variety," Correnti says. "By maintaining a diversified portfolio, you should be better equipped to handle the ups and downs of the markets rather than if you place all of your eggs in one basket."
Lastly, there is one other strategy that deVere's Green suggests for investors trying to make the best of a bad market: Drip-feeding new money into markets at a predetermined pace. In the long term, stock values overwhelmingly tend to rise. If investors want to create wealth over the next decade, short-term be damned, they'll have to put their new money into the market and not sit on the sidelines.
"By contributing extra money to portfolios now, rather than putting it off, investors are able to capitalize on the potential gains of the longer-term stock market projections sooner rather than later," he says. "Putting off investing means the exact opposite, of course."
"Despite the general sense of unease in the markets, by drip-feeding new money into the markets at a steady pace and ensuring portfolios are truly diversified, investors can still build wealth -- it is a matter of proceeding with caution and being highly selective."
While it is easy to feel invincible when the going is good, the Hartford's Diehl notes having a diversified portfolio can also help investors feel protected when the going gets rough. With diversification, when one asset lags, another asset can pick up the slack, helping investors mitigate the pain of a downturn.
"For these reasons and more, diversification remains an important component of building a sound portfolio," he says. "While enjoying the benefits of a bull market, advisors should be careful not to get complacent, and not to let their overly confident clients get too audacious. Continue to preach diversification even during a bull market, so that clients don't get stuck by their proverbial horns in the end."