These are heady times for investors in the U.S. stock market, who just finished 2017 with an 18 percent return in the S&P 500 broad index of large-cap U.S. stocks. These historically rare returns have prompted investors to park funds in the stock market in their greatest numbers since 2000, according to broker TD Ameritrade’s index of investor participation.
While investors may be tempted to go all-in on the rising star of the stock market, there are a couple age-old investing guidelines they could consider to help guard against over-exuberance and limit losses if a correction comes:
Investors can create a balanced investment portfolio by determining ahead of time how much exposure they want in several different asset classes, such as stocks, bonds, international assets, commodities and precious metals. A balanced portfolio purposely invests in asset classes that have:
- Different levels of volatility. Meaning how wide their swings from gains to losses is likely in any given year.
- Limited correlation to each other. Meaning that one asset class tends to rise or be unaffected when the other falls.
Once they’ve established a balanced portfolio, it simply needs to be rebalanced on a regular basis.
For example, suppose an investor decided to create a simple portfolio of 50 percent U.S. stocks, 30 percent international stocks and 20 percent U.S. bonds. After three months, a rise in U.S. stocks may have pushed the portfolio out of balance, with a 58 percent exposure to U.S. stocks, 27 percent in international stocks and 15 percent in U.S. bonds. The portfolio could be rebalanced by selling that extra 8 percentage point gain in U.S. stocks and buying the proper amounts of international stocks and bonds to bring the balance back to where it was three months earlier.
This is a valuable technique because it automatically tends to sell some of an asset class when it is overpriced, and reinvest in an asset class when it is underpriced. This may reduce the overall volatility and improve the total returns in an investment portfolio over time.
The second technique is called automatic investing, which means following a disciplined strategy of regularly investing small amounts over time, regardless of whether the markets are going up or down.
A person who is making regular investments from every paycheck into a retirement investment fund like a 401(k) is already doing a form of automatic investing.
The benefit of automatic investing is that it keeps our emotions out of the process.
For example, an overreaction to a market downturn may cause a person to invest less or sell existing investments when in reality the downturn was only temporary. By sticking with automatic investing, the theory is that shares would be purchased more cheaply during an asset correction.
Conversely, overenthusiasm to a market upturn might cause someone to eagerly dump a lump sum in an asset in the hope of chasing a gain. Over exuberant markets may crash, however, meaning emotions caused an investor to buy when prices were high, and to take a loss when they drop. Automatic investing would’ve spread those purchases out into small amounts, meaning some would be made when the market was high and some when it was low – which cushions the blow from an unexpected downturn.
Remember, both portfolio rebalancing and automatic investing are just basic guidelines that help us avoid being swayed by our emotions when we make investments. Always talk to a qualified investment advisor when you are making investment decisions. He or she can help you carefully weigh the risks and benefits of your strategy.