Financial markets have been taking a hit lately. This rout is causing many individual investors to wonder if there are ways to reduce volatility in their personal portfolios. This article offers some ideas on how to do so.
For investors, 2016 has started like a highlight reel of all that can happen: gut wrenching plunges in stocks followed by breathtaking rebounds; dire forecasts and interludes of optimism; bond yields falling despite predictions they’d rise; economic turmoil around the world, especially in China and other emerging economies. It seems certain this will continue to be a volatile year for investors.
So how can one address all this risk?
Many investors will choose the simplest response — do nothing. And there’s a lot to be said for that given that the broad markets have always recovered from downturns and gone on to new heights. Dumping holdings in a dip — or buying more — can backfire when the market doesn’t do what you’d expected.
“Trying to time the market is not a good idea and has been shown to produce lower returns over time,” says Wharton economics professor Kent Smetters.
Still, even a buy-and-hold investor with a long-term view should be aware of various techniques for reducing risk and minimizing losses — everything from buying “put” options to issuing stop-loss orders, bulking up on cash or simply boosting long-term prospects by minimizing taxes and other costs.
“Trying to time the market is not a good idea and has been shown to produce lower returns over time.” –Kent Smetters
Most experts say that if you were happy with your asset allocation before the year began it’s probably best to stick with that mix for the long term. Asset allocation guides provided by financial services firms assume a long-term strategy that means simply riding out the downturns.
And yet, a minor change in allocations will not necessarily rock the boat. A $100 portfolio of 60% stocks, 30% bonds and 10% cash would rise to $109 if the stock and bond portion rose by 10% and cash earned nothing. Reduce the stock and bond holdings to 80%, and increase cash to 20%, and the entire portfolio would grow to $108 under the same conditions — not a big price to pay for peace of mind. The extra cash could be put back into securities when the rough ride appeared to be over.
The simplest way to boost cash: Tell your broker or fund company to divert dividends, interest and funds’ capital gains distributions to a money market fund instead of reinvesting in stocks and bonds.
It also pays to look at each holding from time to time and ask, “Regardless of how it’s done in the past, would I buy it today?” If the answer is no, it might be smart to get rid of it.
To hedge against losses, sophisticated investors often use put options, which gives its owner the right to sell a block of stock at a set price for a given period of days, weeks or months, insuring the investor can get today’s price no matter how far the price falls during that period. A basket of stocks can be insured with puts on exchange-traded funds (ETFs), such as the SPDR S&P 500 (Ticker: SPY), which tracks the Standard & Poor’s 500.
Unfortunately, put prices — “premiums” — rise when the market grows more volatile. In mid-February, for instance, a SPY put insuring $18,600 in holdings through the end of June cost about $1,100. The cost could be reduced by purchasing a less valuable put — one that would pay off only after the market had already fallen by 10% or more, for instance — but costs would nonetheless grind away at a portfolio if options hedging were used all the time.
Another form of insurance — and a free one — is the stop-loss order, an instruction for one’s broker to automatically sell a block of stock after the price falls to a set level, to escape deeper losses if the price keeps going down. However, there is no guarantee there will be a buyer at the stop-loss price, so the shares might be sold at a lower price – so low the investor might prefer to hold on and bet on a rebound. The investor can add a “limit,” specifying the shares not be sold for less than a given price, but if there is little demand the shares might not be sold at all.
Other risk-control strategies aim not so much at preventing losses as enhancing the investment portfolio through greater efficiency.
One is to minimize annual taxes by being careful to avoid sales that trigger capital gains taxes. Trading that can’t be avoided, such as mutual fund sales and purchases to keep to the desired asset allocations, can be done in tax-favored accounts like 401(k)s and IRAs, which have no annual tax bills. These accounts are also suitable for mutual funds that, in taxable accounts, can incur big tax bills by spinning off lots of cash through dividends, interest or year-end capital gains distributions.
Mutual fund investors can also minimize annual taxes by shifting from actively managed funds that do lots of buying and selling to index-style funds that simply buy and hold stocks.
Mutual fund investors can also minimize annual taxes by shifting from actively managed funds that do lots of buying and selling to index-style funds that simply buy and hold stocks in an underlying index like the S&P 500. Less selling means less tax on “realized” capital gains. The fund’s returns are simply reflected in the fund’s share price, and are not taxed until after those shares are sold. Index funds also charge lower fees than actively managed funds, enhancing returns over time.
There also are some “tax-managed” funds that make special efforts to minimize annual tax bills — such as selling, and later reacquiring, money-losing holdings to offset taxable gains on other investments.
While many investors are focusing on recent stock market gyrations, Smetters urges investors to address another risk.
“The biggest risk people face is not market falls but inflation,” he says, noting that the long period of unusually low inflation will eventually end. Higher inflation, of course, erodes investment returns by making each dollar less valuable.
“Just 2% inflation can erode a portfolio’s value by up to 40% over 25 years,” Smetters says.
Investors can hedge against this risk with Treasury Inflation-Protected Securities, a type of U.S. government bond that rises in value at the inflation rate, in addition to paying interest, which is currently around 1% for a 30-year bond. So if inflation were 2% the investor would earn 3%.
The Series I U.S. Savings Bond works much the same way, combining a fixed yield with one based on inflation. Currently I Bonds yield 1.64%, which isn’t much but will go higher if inflation kicks up.
“You never hear about I Bonds because the high-fee [financial services] market hates the competition,” Smetters says. “But it’s an easy way to build a solid low-risk portion of one’s portfolio over time.”