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For this month's Wealth IQ Report, we discuss smart steps investors should take to help stabilize their portfolios during periods of market volatility.
Please feel free to contact me at (888) 944-7736 if you have any questions about this article and how it may pertain to your situation.
Sincerely,
Darren Whissen
Seven Smart Steps in a Volatile Market
Judging from the past few months, it's not a stretch to suggest that recession and inflation are rearing their ugly heads, and that many investors simply don't know how to respond. Market volatility is extremely high, and negative days are outnumbering good ones. As of the end of July, 2008, the DJIA was down 13.4% YTD and the S&P 500 was down 13.1% YTD.
While it's difficult to ignore the market's daily ups and downs, some investors may be prompted to take erratic actions that ultimately will hurt themselves. For example, some might be tempted to sit in cash until the "crisis" is over. However, they're likely to miss some of the market's best days.
Rather than try to predict the future or control what you can't, I recommend investors focus on things you can control and complete the following seven steps to help improve your portfolio performance:
1. Review your asset allocation.
If you're concerned about what's going on with your portfolio, that could be a sign that your current portfolio mix isn't appropriate given your time horizon and risk tolerance. If you haven't examined your asset allocation lately, that's a great start to evaluating whether your portfolio is on track.
To help see where your portfolio stands currently, I offer a complimentary portfolio X-Ray, which uses Morningstar's premium tool to see your stock/bond/cash mix, as well as your sector and style-box positioning and your exposure to foreign stocks. Click here for a sample of an X-Ray.
2. Reduce portfolio expenses and tax costs.
While this information is never disclosed on your statements, you may by holding investments with high investment-related expenses, such as management fees, or that are terribly tax-inefficient. A quick review of these factors can drastically improve your net performance.
As part of my complimentary X-Ray, I can examine the underlying expense ratios for each mutual fund in your portfolio and make recommendations on other funds that have the same market exposure, but that are much cheaper to own.
3. Improve tax efficiency.
Now is as good of an opportunity as any to review the tax costs associated with your investments and to make sure that you're taking advantage of any ways to shelter your holdings from Uncle Sam.
To the extent that you own securities that kick off a lot of current income, which is taxed at your ordinary income tax rate, consider storing those investments in a tax-sheltered account such as an IRA, Roth IRA, or Variable Annuity. For your taxable accounts, consider separately managed accounts, municipal-bond funds, and tax-managed funds the mainstays.
4. Check the number of eggs in your basket.
You always hear about the merits of a well-diversified portfolio, and you can see those benefits in action by looking at the Category Returns page on Morningstar.com. Most stock funds--even international--have been lousy so far this year, but bonds have had minimal to no losses. Those trends could easily reverse themselves in the months ahead, but those who have taken care to diversify across asset classes and industries have at least muted their portfolio's losses somewhat.
Moreover, the recent travails Bear Sterns should reinforce the importance of not gorging on your company's stock. A reported 30% of Bear's stock was in employee hands, and Bear's drop from $30 to $2 over last month no doubt inflicted a world of pain on many of these employees' portfolios. I know that it's easy to argue that your company is different/better than ill-starred firms like Bear and Enron. But if you're a big company stockholder, you'll want to ensure that you've augmented those holdings with stocks and funds that give you exposure to other industries.
4. Take a close look at your mortgage.
Even if you weren't speculating in the real estate market or using your home as a piggybank, the housing sector's meltdown still carries some important lessons as well as opportunities for savvy homeowners. In particular, declining or flat-lining home values argue for a more aggressive mortgage-pay-down schedule than many financial planners have historically recommended. Moreover, the recent drop in the LIBOR may translate into a good opportunity to refinance your current mortgage at a more affordable rate; you may also be able to painlessly reduce the term of your loan at the same time. Ask your mortgage broker to model out what your payments would be if you switched from a 30-year mortgage to one with a 20-, 15-, or 10-year term.
5. Assume we're in a recession.
While economists, politicians, the media, and just about everyone else continue to debate whether or not we're in a recession, the safe play is to just assume it's true. With that distraction out of the way, you can now start building a strong defense. Dust off your resume, cut back on your spending, and also make sure that you have built an emergency fund in case you should lose your job--three to six months' worth of living expenses stashed in ultra-safe securities such as CDs or money market funds. (You'll want to save even more if you have a high-paying job, as it can take longer for highly paid individuals to find a comparably paying position.)
6. Build a strong defense.
While recessions are serious, inflation is the real killer. Just think about how much it costs now to buy groceries or refuel you vehicle. Unfortunately, inflation also has deleterious side effects for your portfolio, because it erodes the future purchasing power of your investment dollars and it also creates a more challenging environment for the businesses you might be investing in. Unfortunately for those looking to protect themselves, there aren't that many places to hide: Inflation hurts both stocks and bonds. Moreover, many of the traditional inflation hedges--such as commodities, Treasury Inflation-Protected Securities, and commercial real estate securities--are arguably pretty pricey.
Despite that generally discouraging picture, large-company stocks, especially those with what we call "economic moats" and global footprints that give them the opportunity to benefit from global growth, are apt to hold up better in a recessionary environment than smaller company stocks.
7. Look for opportunities.
Last but not least, a lousy market environment always has a silver lining: even good securities are unduly beaten down. If your time horizon is long enough, this is an excellent opportunity to be on the lookout for high-quality companies that are trading cheaply. Also, municipal bonds are trading cheaply right now. That means munis could make sense for you, even if you're not in the highest tax bracket.
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Disclosures
A Note about Risk: The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy. The value of an investment in debt securities will change as interest rates fluctuate in response to market movements. When interest rates rise, the prices of debt securities are likely to decline, and when interest rates fall, the prices of debt securities tend to rise. Investments in high-yield securities, sometimes called junk bonds, carry increased risks of price volatility, illiquidity, and the possibility of default in the timely payment of interest and principal. Although U.S. government securities are guaranteed as to payments of interest and principal, their market prices are not guaranteed and will fluctuate in response to market movements. There is a risk that a bond issued as tax-exempt may be reclassified by the IRS as taxable, creating taxable rather than tax-exempt income.
The opinions in the preceding commentary are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole.
This material is not intended to be relied upon as a forecast, research, or investment advice, is not a recommendation or offer to buy or sell any securities or to adopt any investment strategy, and is not intended to predict or depict performance of any investment. Investing involves risk, including possible loss of principal. Investors should consult with a financial advisor prior to making an investment decision.
Diversification does not guarantee a profit or protect against loss in a declining market.
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