The first half of 2021 was very different than the volatile first six months of 2020. To that point, the Standard & Poor’s 500 Index returned 15% in the first half of this year — healthy growth in just about any full year.
Yet, with the potential for inflation to jam the gears of growth — fueled by trillions of dollars in past and potentially future stimulus spending — there are concerns about how investors should adjust their portfolios for the second half of 2021.
Now is the time to focus on managing risk by reviewing what many investors appear to be ignoring: diversification. To be sure, there are reasons to believe that diversified portfolios can do well, even with the uncertainty of inflation and rising interest rates.
Admittedly, there is a downside to diversification, which is if stocks continue to post record gains, you will probably make less money. However, some exposure to a mix of assets such as non-U.S. dollar denominated stocks, value stocks, corporate bonds and foreign bonds could be very beneficial if something eventually goes wrong.
stocks, value stocks, corporate bonds and foreign bonds could be very beneficial if something eventually goes wrong.
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Despite the stock market’s historic run over the past couple of years, I often remind clients that U.S. large cap stocks don’t always produce the best returns. For example, for the 15-year period from 2000 through 2014, bonds actually outperformed U.S. large cap stocks.
Almost no one I speak with thinks this could possibly be true, despite most actually having experienced it. Recency bias, or the behavioral trait of extrapolating what happened in the short-term as tough it will occur into perpetuity, is common when it comes to investing.
As we enter the second half of the year, here are five ways to make sure your portfolio is diversified, positioning it for growth while hedging against a possible downturn:
- Invest in underperforming market segments: Consider investing new money in stocks from emerging markets, developed foreign countries, and U.S. value stocks such as energy and financial services companies. I wouldn’t recommend loading up on these investments or aggressively selling the top-performing securities you already own. Instead, simply don’t neglect the underperforming areas of the market by using new money to invest in these areas to help balance out your portfolio.
T. Rowe Price’s Sebastien Page on asset allocation, diversification
- Rebalance your portfolio: The S&P 500 has returned about 40% over the 12 months ending June 30. Anyone using a traditional target allocation between stocks and bonds should consider adjusting their portfolio so it has the right proportion of assets that fits their financial plan.
This is a good strategy to use if you don’t have money available in the coming months to help rebalance through new investments. For example, by taking a portfolio now at 70% to 75% stocks back to its original 60% target, risk is reduced.
This strategy may sacrifice some investment return, but rebalancing attempts to implement a “buy low, sell high” strategy and protect against a possible future bear market.
- Stick with bonds and limit exposure to U.S. Treasurys: Despite the low yields on bonds throughout the U.S., bonds still provide diversification benefits. Anyone who believes they cannot time the market will benefit from this strategy because if something goes terribly wrong, bonds have historically provided better safety than stocks.
While this data may have slipped under the radar, U.S. Long Government bonds returned 6.5% and U.S. Core bonds 1.8% in the second quarter of the year as inflation fears subsided. U.S. Long Government bonds are very sensitive to interest rates and will likely perform poorly if inflation picks up.
For those more concerned about inflation, focusing on corporate bonds with varying degrees of credit risk is a good option.
‘Diversification is for the know-nothing investor’
For investors with stock portfolios, I have two recommendations:
- Compare your sector allocation to the S&P 500: Another way to manage risk within a portfolio is to take a “market-neutral” approach when it comes to building a portfolio. Investors who own individual stocks can compare the overall weighting of their stock portfolio by sector to the S&P 500 and adjust it to make sure it is similar to the index.
Without such a strategy, investors often end up chasing a favorite sector or a couple of high-flying stocks which increases risk. This usually results in an imbalance among sectors compared to a well-diversified index such as the S&P 500.
By failing to use a market-neutral strategy, investors could easily be overweight in technology, health care and communication services because these sectors have performed exceptionally well of late. Accordingly, many investors are underweighted in less popular areas such as energy, financials and industrials due to their lackluster performance.
- Trim stocks that have appreciated significantly: Many investors are seeking some extra cash to pay for travel and other items now that the economy is reopening. Taking gains from top-performing stocks is an excellent strategy to help reduce risk. Quite oftentimes, investors want to limit the amount of taxes paid when making withdrawals. While this may be optimal under certain conditions, in most cases it makes more sense to focus on investment risk, not taxes.
By trying to minimize the tax bill every time a stock is sold, an investor could eventually be left with a concentrated portfolio of just a handful of stocks. If the market keeps moving higher, holding on to your top performers will likely be a great strategy.
But if market trends ever shift, it could severely damage a portfolio since the stocks with lower gains or losses that were sold likely would have held up better during a market reversal. When a withdrawal is needed, trimming the winners is a risk management strategy that helps keep you diversified.
As always, no one knows where the market is headed over the next couple of months. It could continue marching higher and keep investors smiling, or not.
Regardless of what happens with inflation, Covid-19 variants or an unpredictable market event, managing risk is crucial when it comes to seeking, or maintaining, financial independence.
