Some investors have become complacent about stock market returns following years of positive performance. But what goes up can come down; so now may be a good time to review your asset allocation in your portfolio.
This year has been a remarkably placid one for investors so far, but tense communications between the United States and North Korea has some pundits discussing whether geopolitical worries could be the catalyst for the long-anticipated market sell-off.
As always, it is near impossible to predict short-term market movements. But the length and breadth of the current stock market rally make it a good time to revisit portfolio allocations. Well-meaning investors who are practising a buy-and-hold strategy can end up, inadvertently, with an investment mix that is riskier than their appetite because they have let their winners run.
Here are five steps to conduct a quick portfolio stress test.
Check Your Stock/Bond Mix
In strong markets like the bull market that has prevailed since early 2009, most investors tend to leave their portfolio alone. But if you have not reviewed your portfolio's allocations recently, use the market volatility as an impetus to do so.
A hands-off portfolio that was 60% equity/40% bond in early 2009, for example, would be more than 80% equity today – and you're eight years older. That means for many investors a rebalancing is called for. Rebalancing can help align your portfolio’s allocations with your risk capacity, which is your ability to withstand losses without having to alter your plans.
Investors younger than 50 have high risk capacities in most cases. Thanks to employment income, they will not need to access their investments any time soon. But investors getting close to retirement will want to prioritise capital protection; their risk capacities are lower.
Assess Liquid Reserves
In addition to checking your portfolio's long-term stock/bond allocation, it's also a good time to check up on your allocation to liquid assets such as cash. The last thing you want to do is be forced to sell equities when they have fallen in value to meet unexpected expenses.
Those in retirement should consider holding one to two years' living expenses in liquid reserves, alongside a long-term portfolio composed of stocks and bonds. For people who are still earning a salary, three months’ living expenses in liquid reserves can make a solid emergency fund.
If you have lumpy, ongoing expenses you'll have to meet within the next year, such as your child’s education costs or a tax bill, you should earmark additional assets for those, separate from your emergency fund.
Opportunistic investors may want to set aside some liquid assets to have ready money to pick up bargains when stock markets fall. Investors should shop around for the best savings rates, as interest on offer has dropped significantly over the past 10 years.
Dig into Sub-allocations
Your portfolio's allocations to the major asset classes will be the key determinants of how it behaves. But before you conduct any rebalancing, check up on your portfolio's sub-allocations: its exposures to various sectors, investment styles, and geographies.
If you have determined it's time to trim back your portfolio's equity exposure, you'll want to concentrate on the portions of your portfolio that have enjoyed the most dramatic appreciation. So far in 2017, the technology sector has made great gains, as have emerging-markets equities.
Make Sure Your Ballast is Just That
If you've decided that it's time to top up your bond exposure after a long period of downplaying the asset class, pick your spots carefully. High-risk fixed-income assets such as emerging-markets and high-yield bonds may entice with their strong near-term returns, but such bonds often struggle more than high-quality bonds in equity-market shocks.
If you're seeking true ballast for the equity piece of your portfolio, focus on boring, high-quality core fixed-income funds.
Recognise How Much is in Your Hands
Last but not least, the long-running strength of the equity market has meant many investors are unaware that their own actions can have an even bigger impact on whether they meet their financial goals than market returns. But it's true.
Even though the market has contributed generously to investors' accounts over the past decade, there will invariably be periods of significant losses. In times like those, investors can take comfort in all of the big decisions that are in their hands: their household expenditure, how much they save every month, and their use of tax-efficient SIPP and ISA wrappers.
Being deliberate about all of those decisions is the best way to take back control, even if the market's future returns are less compelling than they've been in the past.
