The bull rally can’t last forever, so take steps now to prepare for a pullback
If you’ve taken a look at your 401(k) statement recently, you may have felt a mix of elation and worry. Sure, it’s great to be earning double-digit returns. But the last time stocks rallied like this was just before the 2008 to 2009 financial crisis, when the market plunged by almost 50 percent.
For those who managed to hang on, stocks have been on a near-nonstop bull rally ever since. Following the market bottom in March 2009, the Standard & Poor’s 500 Index has posted a cumulative return of almost 300 percent, or an average annual return of 19 percent. Last year alone the S&P 500 gained nearly 22 percent.
But at almost 9 years old, this bull market now stands as the second longest in modern stock market history, which means it may not have much further to run. (The longest bull market, which lasted through the 1990s, ended in early 2000 with the dotcom implosion and a 21⁄2-year bear market.)
“This is definitely a mature market, as well as a mature economy,” says James Stack, president of InvesTech Research in Whitefish, Mont., who tracks market history. “It’s time to be more defensive.”
Of course, no one can accurately predict when the bull market will end. Stocks may continue to rise, buoyed by a strong economy and corporate earnings growth. But even the most powerful rally eventually runs out of steam, and history shows that a political or economic shock could trigger a correction or even a bear market.
It is clear that the rally has pushed up stock prices to lofty levels. The S&P 500 recently traded at about 24.6 times corporate earnings for the past 12 months, which is far higher than the historical average of 17.
“Given those high stock valuations, investors are less likely to see big gains ahead, unless corporate earnings can close that gap,” says Stack. “And an expensive stock market means the next bear market may result in more severe losses.”
Before that happens, make sure your finances can weather a market drop, especially if you are in or near retirement, with less time to bounce back from losses. Don’t abandon stocks altogether, though, because you need to own equities for long-term growth. But consider making a few tweaks to your portfolio, and perhaps even taking some profits, if only to sleep better at night. Here are five moves that may help you ride out a downturn:
1. Review Your Asset Mix
Chances are, you haven’t updated your portfolio allocations lately—few 401(k) investors make any changes after signing up. But what was right for you in your 20s or 30s may be too aggressive for someone in their 40s or 50s, when your investing time horizon is much shorter.
To figure out what mix works for you now, stress test your risk tolerance. Say stocks plunged 50 percent, similar to what happened in the 2008 to 2009 bear market. If you hold 70 percent of your portfolio in stocks and 30 percent in bonds, that move might erase one-third of your portfolio. Perhaps you muddled through without panicking in the last financial crisis, but would you be able to hang on now? If you’re married, how would your spouse feel about those losses?
For those who would rather not see a rerun of that scenario, shift a portion of your stocks into bonds for a tamer asset mix, says investment adviser William Bernstein, author of “The Four Pillars of Investing.” Instead of a 70/30 stock-and-bond mix, opt for a 60/40 or 50/50 allocation instead, which would limit your losses. By scaling out of stocks, you will also be locking in some of your profits.
2. Rebalance Your Portfolio
Choosing an asset mix does no good if you don’t maintain it through rebalancing. According to the investment firm Vanguard, someone who started in 2012 with a 60/40 stock-and-bond mix and failed to rebalance would have a 74/26 mix today, as a result of the big gains in stocks and modest returns in bonds.
“A market correction would bring your portfolio closer to your original allocation, but that would be doing it the hard way,” says Jim MacKay, a financial planner in Springfield, Mo.
A better strategy is to rebalance. To do this, sell just enough of your winning investments and add that money to your laggards to bring your portfolio back to its original allocation, or the one that is right for you today.
“Rebalancing is counterintuitive, since you sell high and buy low, which is hard for most people to do,” says Francis Kinniry, principal in Vanguard Investment Strategy Group. “But if you rebalance once a year or so, you typically find you only need to make small tweaks, perhaps shifting 2 percent of your portfolio.”
An even simpler strategy is to opt for an all-in-one fund, such as a target-date retirement fund, that automatically rebalances for you across a wide range of assets.
3. Diversify Overseas
“Most investors have on blinders and only buy domestic stocks and avoid foreign stocks,” says Rob Arnott, founder and chairman of investment firm Research Affiliates.
The U.S. accounts for only about 53 percent of the global stock market. But unless you are enrolled in a target-date fund, you probably hold little foreign stock. Only one-fifth of 401(k) savers hold an international stock fund, if one is offered in their plan, Vanguard data show.
Granted, foreign stocks tend to be riskier than U.S. equities, especially shares of companies based in emerging markets. But overseas stocks are an important source of diversification, because they don’t move in lockstep with U.S. stocks—they often zig when Wall Street zags, which can reduce risk over the long term.
That’s why you should consider stashing a portion of your equity stake in overseas stocks. As a benchmark, for someone planning to retire in 20 years, a typical 2040 target-date retirement fund holds 30 percent or more of its stock allocation in foreign equities.
4. Focus on High-Quality Bonds
In December the Federal Reserve continued its program of slow, small interest rate rises with another 25 basis points hike. That’s putting pressure on bonds, which fall in price when rates rise. Since the start of the year, the iShares Core U.S. Aggregate Bond ETF (AGG), which tracks the overall U.S. fixed income market, has dipped 0.57 percent.
Still, bonds remain an essential asset in your portfolio, because they provide a cushion against the risk of stocks. So to hedge against rate hikes, opt for a diversified bond fund, which holds short-, intermediate-, and longer-term issues, MacKay says. Over time, you’ll earn most of the return of bonds with minimal volatility.
Be sure to stick with high-quality bonds—those that hold investment grade and government issues. Lately investors have been flocking to lower credit-quality issues, such as junk or below-investment grade bonds, which may pay higher yields, Vanguard data show. But the risks of those issues closely mirror those of stocks. If the economy slows, low-quality bond holdings may take a big hit, along with your stock portfolio, Kinniry says.
5. Step Up Your Saving
Although you may not be able to earn hefty returns in the coming years, there’s one key factor you can control—your savings rate, Bernstein says. Boosting the amount you stash away means you will be less dependent on high returns to reach your financial goals. And you don’t have to take a lot of risk to get there.
To make sure you save more, automate your contributions, starting with your 401(k) plan, and try to put away the max, which is $18,500 in 2018 (those 50 and older can put away another $6,000). For IRA investors, the max is $5,500; those over 50 can contribute another $1,000.
Can’t save that much? Hike your contribution rate another percentage point or two for now, and aim to increase it more in the future. And if you get a raise, or receive a windfall, stash some or all of the money away. That way, your portfolio will stay on track, whatever the market does.