Four Ways to Lower Portfolio Risk in a Record Stock Market
January 20, 2015
Want a hot tip on the stock market? It’s more profitable to reduce risk at the top of the stock market than once a full-blown bear market develops. Is now the top of the stock market? We can’t know for sure, but what we do know is that the market remains in record territory, and that’s when it’s time to take steps to reduce your portfolio risk.
What can you do now to lower that portfolio risk?
Take some profits
There’s no need to perform a wholesale liquidation of your stock portfolio if you feel the market is flying a bit too high. But you can take some profits in order to reduce your overall exposure to stocks, while leaving most of your positions intact. That’s a good strategy because market tops are notoriously hard to anticipate, and stocks can continue rising for much longer (and farther) than anyone thinks.
But if you have stocks that have done particularly well for several years, you might consider selling them to take profits. By selling stocks that have done well, you are locking in your gains on those trades. Sooner or later, the market will fall, and if the fundamentals of those winning stocks are still strong, you can buy them back at lower prices.
Stop funding new stock purchases
One of the best ways to lower your risk in a record stock market is by not investing fresh cash contributions into more stocks. You don’t sell your primary stock positions (other than the profit taking on the best performers as discussed above), but you increase your non-stock positions (cash) with the new money you contribute.
This will lower your stock allocation without selling off large blocks of stocks. You can use the money either to build up cash, or to invest in assets that might have a better chance when the market turns down.
The time honored technique for making money in the stock market has always been buy low, sell high. Though it may not necessarily be time to sell, by not funding new stock purchases with fresh cash, you will at least avoid buying at the top of the market (or “buying high”).
Increase your cash
By taking profits on some high fliers and not buying stocks with your fresh cash contributions, you’re accomplishing something that’s fundamentally important at market tops: you’re raising cash.
Though some people try to raise cash during bear markets, it’s usually much easier to do at or near market tops. This is because you’re in a position to sell when prices are high, which not only raises greater amounts of cash, but it also avoids selling stocks into declining markets where you will lock in losses on those trades.
Cash is typically the single best asset to have during market downturns for the following reasons:
- It reduces portfolio losses during general price declines because it has a fixed value.
- It can be invested in interest bearing assets, providing at least a small cash flow while equities are losing value.
- It can be accumulated so that you will have ready capital available so that you can buy stocks at bargain prices after a significant fall.
Unfortunately, cash is also perhaps the most under-appreciated asset class at market tops when everyone wants to be “fully invested”. But start building your cash reserves now and when the direction of the market turns, you’ll be in a perfect position to ride out and exploit the changing circumstances.
Move money to income producing assets
We just touched on moving cash into interest bearing assets as a way of generating an income, but you can do this with stocks as well. High dividend paying stocks can often be the perfect place to ride out a downturn in the market. Not only will the dividend income provide a reliable income stream, but high dividend stocks also generally resist market declines, preserving your portfolio’s value.
The one caveat with high dividend stocks is a market decline caused by rising interest rates. In periods of rising rates, high dividend stocks function much like bonds, moving in an inverse direction from interest rates. Thus when interest rates rise, high dividend stocks tend to fall in price.
Still, high dividend stocks can represent a diversification away from typical growth stocks that are a pure play on price appreciation – something that’s in short supply in declining markets.
Have you been giving any thought to lowering the risk in your portfolio with stocks being in record territory?
All posts by Kevin Mercadante