Q. When I check the news every day, the stock market is setting new records. Can this really continue and how should I prepare my portfolio for when it stops?
A. Investor euphoria, and conversely concern, is rapidly growing due to the U.S. stock market’s rise to all-time highs. Investors are asking how high is too high and how long will it last? Nobody knows for certain, but we can expect continued volatility if the bull market continues to mature.
Be prepared. By their very nature, financial markets rise and fall constantly, with an ever-present potential for gain or loss. During periods of new highs, financial markets are often exposed to wide swings in market value. The key is to have a plan in place well in advance of large market selloffs or large market increases.
First, it is important during these periods for investors to avoid emotional responses to investing. If markets fall sharply, some investors will sell all or part of their holdings and shift into what they perceive to be “safer” investments. Such emotion-based selling turns paper losses into real ones and limits any possible gains should the market recover. These same investors often buy when the markets are “hot” and values are rising.
We believe that acting emotionally is one of the top reasons for investment loss as emotional investors are buying high and selling low.
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Studies have identified the top determinant of long-term investment results and provide a guide for how to approach periods of record high markets. The top determinant of long-term investment success is asset class selection (Financial Anal J 1991; 3:40-8).
Asset allocation modeling is an investment strategy that seeks to reduce investment risk by spreading an investor’s portfolio over a number of different asset types or classes. This diversified approach takes advantage of the tendency of different asset types to move in different manners and cycles in an effort to smooth out the ups and downs of the entire portfolio. Stocks, bonds, and cash (or cash equivalents) are the broad asset classes typically used. Tangible assets, such as real estate or gold, may also be included for further diversification. Determining an allocation should be done well in advance of any hot or cold streaks in the market.
If an investor has an asset allocation strategy in place and is well-disciplined about sticking to that allocation, they can ignore much of the outside noise. They don’t have to be concerned about reacting to changes in the market; they understand that this is the natural ebb and flow.