Spreading your investment strategies across a variety of holdings and asset classes is always a good idea in any market climate. Even though U.S. stocks have done very well since the extreme volatility we saw in the early days of the pandemic, a number of potential risks could be at hand. Investors will want to examine the investment strategies they have in place to help ensure that their portfolios are diversified and can handle these risks.
Evaluate how diversified your equity investment strategies truly are.
Even with the short-term blips we have experienced, like the downturn following the initial COVID-19 outbreak, U.S. stocks have been on an extended bull run since the end of the Global Financial Crisis of 2008 to 2009. But that bull market has really been focused on a small set of stocks – generally large-cap stocks and most specifically technology stocks.
The outstanding performance of the mega-cap tech stocks has presented concentration risks for investors who invest in stocks only through the major indexes. The weighting of the biggest companies, by market capitalization, in indexes like the S&P 500, is higher than ever. The diversification investors assume they’re getting may not really be there as the broad indexes provide excess exposure to this small, select group of stocks. Investors relying solely on large-cap ETFs for their equity holdings may need to take steps to more broadly diversify.
U.S. large-cap stocks have also become very expensive. Valuations, as measured by price-to-earnings ratios, on the S&P 500 stocks are well above their historical norms. Past evidence does suggest that the returns you can expect from stocks eventually return to long-term averages. Decreasing any excess exposure to expensive stocks could help you minimize the potential risks to your portfolio.
Diversify your equity investments by sector and size.
Through the early months of 2021, tech stocks have lagged other sectors, like financial services and energy stocks, which have received a boost from the massive COVID-19 stimulus package the U.S. Congress passed. The $1.9 trillion that the government plans to spend could provide fuel for a dramatic economic expansion out of the downturn brought on by the pandemic. Cyclical stocks, such as banks and industrial companies, often do well in the early stages of economic recoveries. You may want to ensure that your diversification investment strategies deliver exposure to the sectors and industries that may perform best in this climate.
For similar reasons, you may also want to ensure that you have adequate exposure to small- and mid-capitalization stocks. While they carry more risks than large, established companies do, small- and mid-caps have the potential to grow at faster rates and can perhaps take greater advantage of the pick-up in economic activity at the beginning of an expansion.
Don’t aim to be trendy with your style exposures.
Until recently, the U.S. stock market’s extended bull run out of the Global Financial Crisis had been led by growth stocks. While value stocks did have a few short bursts of outperformance, they underperformed growth stocks for most of that decade-plus run. Some market observers even proclaimed the growth vs. value debate was over.
The market rotation finally came, though, when the availability of COVID-19 vaccines was announced at the end of 2020. Since then, value stocks have generally outperformed.
That is perhaps not surprising, given that value stocks often fare better in the early stages of an economic recovery. During such times, as economic conditions improve and more companies do well, the gains growth stocks provide also become less rare and investors are often less willing to pay a premium for them.
For anyone seeking an effective diversification strategy, it’s probably best not to get too caught up in the growth vs. value debate. The market rotation from one style to next usually comes quickly and unexpectedly. A better approach may be to always maintain some exposure to both styles. That way, you never have to try to time the market.
Today, even those investors who already had exposure to both styles may still want to examine how much they currently have allocated to each. Given growth’s extended run of outperformance, investors may be more exposed to growth stocks than they would like. Taking the opportunity to rebalance one’s holdings and increase an exposure to value stocks, if it seems low now, may enable investors to take greater advantage of any opportunities value stocks have to outperform in this environment.
For a long time, U.S. stocks have been the place to be. Still, it’s not wise to assume they’re the only game in town. Once again, if you look over longer timeframes, such as two, three or four decades, you will find prolonged stretches when international stocks outperformed their U.S. counterparts.
Additionally, while it may seem that most industries operate in global markets, it’s still true that different factors influence the markets of North America, Europe, Latin America, and Asia. Ensuring your investment strategies span the globe will help ensure that you can pursue the opportunities and manage the risks associated with each region of the world.
As a globally diversified investor, your fortunes won’t be tied entirely to what’s happening in the United States.
Prepare for the advent of higher interest rates and potentially higher inflation.
With interest rates still well-below the historical average in the United States, and even negative in some countries, there really is only one direction for interest rates to go. Still, in March, the U.S. Federal Reserve decided the U.S. economy may still be too fragile to raise rates, and it elected not to take any action on rates. The Fed even projected that rate hikes may not be necessary until the end of 2022 or even 2023.
If government stimulus packages and central banks’ monetary policies do help spur growth for the U.S. and other global economies, they may heat up sufficiently for central banks to consider rate increases.
Inflation has picked up slightly, but still remains modest. But it too could increase if economic growth rates gather a head of steam.
For investors, it could be time to prepare for the eventuality of higher interest rates and rising inflation. Again, it may be wise to maintain a level of diversification that prepares your portfolio for any scenario.
As rates eventually increase, the price of long-term duration bonds will consequentially suffer. Investors will want to make sure they have sufficient exposure to short-term bonds, whose prices have much less sensitivity to changes in interest rates.
To prepare for the possibility of higher inflation, investors may want to consider investments like Treasury Inflation-Protected Securities (TIPs). These provide built-in protection against inflation, as the income levels they deliver will increase to offset the impact of rising inflation.
Think beyond stocks and bonds.
When inflation is on the rise, people also often want to increase their exposure to real assets, which include real estate or commodities such as gold. The forces that drive the prices of real assets and commodities are often quite distinct from the economic factors that influence stocks and bonds, so diversifying into commodities is another way for investors to both seize the opportunities and mitigate the risks that arise in a variety of scenarios.
Even if the Fed does not appear to be concerned about the prospects of higher inflation, some analysts still believe it could loom in the near future. Higher inflation often leads to a weaker currency. For investors, gold can be an effective hedge against the dollar because its performance has often been negatively correlated with the exchange value of the dollar, as shown in the chart below.
Find the balance that is right for you.
The outstanding performances of certain categories of stocks may have delivered very welcome returns in recent years. Still, to protect yourself against the very real possibility that markets will favor other types of other investments in the months and years ahead, you may be well served to ensure your portfolio has a broad, diversified exposure to a variety of opportunities.
Of course, your portfolio decisions must also be driven by your specific goals, time horizon, and tolerance for risk. As is the case with many things in life, moderation is often best.
A portfolio with balanced exposure to a variety of investment strategies may not be able to capture all of the returns to be had when one particular investment is soaring. Still, it also won’t absorb the full risks of a major downturn in one market.
Rollercoasters may be exciting at amusement parks. When it comes to investing, though, even investors with a high tolerance for risk often prefer a smoother ride given that their holdings that must help them finance the long-term goals they have like paying for children’s education or retiring comfortably.