Lean too far over your skis on the slope and you are bound to fall hard on the landing. Given it’s summer time, try leaning out over your water skis and you risk getting tripped up by the waves. When constructing your portfolio, avoid concentrating your positions in one asset class, sector, stock, type of bond, or range of maturity. Spread out your risks so no one position determines the outcome of your financial goals.
Equally weight the sectors in your portfolio. Focus your portfolio’s return on the asset allocation mix and the intrinsic value of each individual position. Equally weighting the sectors in the portfolio avoids a story falling out of favor. For example, one of the “great” bubbles was the run into alternative energy stocks, particularly solar stocks, in 2007/08 as the price of oil went to $147 per barrel. Investors were convinced that by 2017 all homes would have solar panels. Clearly this has not come to fruition. With oil now at $45 per barrel, and government subsidies fading, the sense of urgency for alternative energy, from an economic standpoint, has lessened. As a result, solar stocks collapsed with most of the publicly traded companies now out of business.
Don’t fall in love with a stock after it has appreciated in your portfolio. We all love to stare at a winner. However, don’t be blinded by the green in the portfolio as that one position appreciates to a dominant size and overtakes the returns of the portfolio. Many investors loved WorldCom. The stock was growing in leaps and bounds. It was the company of the future. Then, word leaked of accounting fraud, the CEO was arrested, and the company went bankrupt. If WorldCom appreciated to a large portion of your assets at the time, your hard-earned savings would have been crushed. Prevent this by equally weighting your positions at the time of purchase, and scaling them back if they appreciate to 4% of your portfolio (based on a 40 stock portfolio with each position at 2.5%).
Don’t out smart yourself in the fixed income allocation of the portfolio. Allocate your fixed income to different types of bonds. Don’t own all corporates, particularly high yield. Yes they are fixed income, but if you have a large exposure to stocks, owning corporates gives you similar exposure to an earnings cycle. In a recession, as earnings go down, so too does the cash flow of a company and with it comes risk to the bond. Plus, the correlation of high yield corporate bonds to US Large Cap stocks is .75. When stocks go down, so too will high yield bonds. If you own high yield bonds, classify them as equities. Don’t be afraid to allocate to US Treasuries, Agencies, and Muni bonds, simply because the current yield is low. Understand that the purpose of owning bonds in the portfolio is to protect the downside, not beat the market.
Don’t forget to spread out your maturity schedule. A typical fixed income strategy is to own bonds over a ten year period and create a laddered portfolio. Concentrating your bonds over a certain period, say short term (1-3 years), intermediate (3-7 years), or longer term (7 years +) implies two things: One, you are smart enough to know where interest rates are going to be at a certain time. Two, particularly in longer dated bonds, you are stretching for income for lack of alternatives.
Guessing what the Fed will do with rates at a certain point has been exactly that, a guess. So many variables come in to play in the Fed’s decision. They have publicly stated their action on rates has been influenced by global politics (i.e. Brexit), stock market volatility, and the health of the global economy (particularly China). Trying to determine these variables, in conjunction with the Fed’s target, assumes your crystal ball is better than mine.
Concentrating your bonds with longer maturities to pick up yield adds enormous inflationary risk to the portfolio. In the future, inflation will most likely be higher and the yields and bonds worth less.
Constantly focus on managing risk in your portfolio. Making sure your allocations stay balanced will help cut a line through the wave of volatility in the market. When it comes to risk management, the key is to be smart enough to know you are not the smartest person in the room.
Note: John J. Petrides, MBA, is a Managing Director and Portfolio Manager at Point View Wealth Management, Inc., a registered investment advisor at 382 Springfield Ave., Summit.
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