However, the recent spike in market volatility has provided an opportunity for investors to experience drawdowns for the first time in over a year. Rather than giving into market inertia, investors should use this aging bull market and rise in volatility as an opportunity to reevaluate goals, allocations, and risk preferences.
An object in motion tends to stay in motion; that is, until acted upon by an outside force. There are five simple steps to take before a correction or bear market catches you off guard and erases a good portion of the gains earned over the last nine years.
1) Take Inventory of your Portfolios
In an extended bull market, it is easy to lose sight of risk management. Investors typically do not complain about upside risk. Many investors have taken on additional risk to keep up with arbitrary market benchmarks or in reaching for yield in a low rate environment. The recent market pullback is only a small taste of ugly that would worsen during a bear market. Take inventory of your client’s portfolios and consider increasing the allocation to risk managed investments that have the flexibility to better navigate a negative equity market. Understanding how investments will behave to the downside is critical.
2) Create or Replenish a Cash Reserve
3) Be Realistic and Reassess your Risk Tolerance
If you have accumulated concentrated positions in high-performing investments, consider paring back these positions in favor of investments that have not performed as well. Valuations have become stretched in many areas of the market, and investments that have appreciated the most are likely to experience the most dramatic corrections. Think of tech stocks in the late 1990s, real estate in the mid-2000s, or cryptocurrencies today. Asset bubbles are attractive when working, but they eventually burst.
4) Review Fixed Income Allocations
For example, broad market fixed income benchmarks have become heavily weighted towards government bonds since the 2008 financial crisis. Index-oriented strategies may be exposed to significantly more interest rate risk than you realize. Alternatively, strategies that can actively adjust portfolio duration and overweight credit-sensitive sectors are typically more resilient to rising rates.
5) Rebalance Opportunistically
Investors have aged alongside this bull market and are likely less risk tolerant than they were nearly a decade ago. If you have shifted your client’s portfolios to favor passive investments over the last several years, now may be a good time to reconsider risk managed strategies. While it is much more sensational to declare risk management dead, the performance of risk managers is generally cyclical, and risk managed strategies tend to outperform their passive counterparts in down markets because of their ability to raise cash and overweight defensive sectors relative to the broad market.
Passive strategies, on the other hand, will continue to track the market and participate in the downside of the indexes they track. Consider using the next several months to opportunistically rebalance away from passive investment strategies in favor of more risk managed strategies that have the flexibility to provide downside protection in a negative market.
For advisors, properly managing your client’s expectations and understanding their attitude toward risk (i.e., temporary portfolio losses) is essential to maintaining a level head during periods of market turmoil. Taking the appropriate steps now can help prevent unnecessary portfolio losses that are difficult to recover from.