Rising stock prices may be a cause for celebration among some investors and a source of anxiety for others. Just look at the current state of the market.
As stocks keep climbing higher, investors are left wondering what happens when a correction snaps the market back to reality. “There’s no doubt we’re seeing all-time highs in the market,” says Kyle Whipple, financial advisor at C. Curtis Financial Group in Plymouth, Michigan. The Dow Jones industrial average and the Standard & Poor’s 500 index recently hit intraday records, with the Nasdaq composite trailing close behind.
Whipple says the cyclically adjusted price-earnings ratio, which smooths out shorter-term earnings swings to assess long-term market valuation, is higher than it was before the financial crisis and the market crash that followed. “As the saying goes, what goes up must come down,” he says, and it’s a matter of when, not if, stocks fall.
[See: 7 ETFs for a Solid Portfolio Defense.]
Although you can’t change the market’s direction, you can control how you invest during market peaks. Instead of worrying about the next correction, “make sure you have a portfolio that you’re confident in, regardless of which way the market goes,” Whipple says. Here’s how to invest as you ride the cresting wave of a market upswing.
Pick an asset allocation target and stick to it. Rebalancing is important any time you invest but even more so when the market is peaking. “Timing the market is notoriously difficult because to do it successfully, investors have to get two calls right — when to reduce risk and when to restore it,” says Albert Brenner, director of asset allocation strategy at People’s United Wealth Management in Bridgeport, Connecticut. “That said, making tactical adjustments within the upper and lower limits of a client’s basic risk exposure can make sense.”
On what basis and over what time frame should those adjustments be made? Investors should take the long view and not base those changes on a short-term market outlook. Anticipating when a recession is likely is key. The higher the odds of a recession, “the lower the equity allocation should be, within the limits of the overall risk objective,” Brenner says.
Keep your target asset allocation in mind as you rebalance, says Michelle Herd, senior client advisor with TFC Financial Management in Boston. “In an equity bull market like we’re experiencing, your asset allocation may have shifted to a higher percentage of equities than your target,” she says. When markets are up, it’s instinctive to continue to ride the trend or even invest more, but “the reality is that the disciplined investor needs to rebalance back to targets, regardless of their emotions.”
Maintaining the right balance between risk and return during market peaks hinges on choosing appropriate asset allocation targets and rebalancing to those targets periodically, Herd says. Your goals and time frame shape your baseline for risk.
Look for investments that don’t share the same market risks. As you rebalance, consider other investments besides stocks, mutual funds and bonds. Investors worried about losses may want to choose alternatives that aren’t correlated with stock market risk, such as non-traded real estate investment trusts, non-traded business development companies or income-generating real estate, Whipple says. A fixed or fixed indexed annuity may also be an appropriate complement to a market-driven portfolio, he says.
While these investments may have less correlation to market volatility, they bear their own degree of risk. Whipple advises discussing them with a financial advisor to determine whether any are a suitable choice when market highs have you on edge.
[See: 7 Ways to Trade Volatility With ETFs and ETNs.]
Move more of your portfolio into cash. In a booming market, it may seem counterintuitive to allocate more of your portfolio to cash, but it could soften the blow later when a correction occurs. Having cash in reserve helps insulate a portfolio from stock price declines.
How much to allocate to cash depends on your comfort level. Mike Falco, financial advisor at Falco Wealth Management in Berwyn, Pennsylvania, says 30 to 40 percent in cash is a good target, and although you don’t need to reach that benchmark right away, you may want to start shifting more investments to cash while the market is still high.
Of course, cash investments don’t generate the same level of return as stocks during market highs, but they do offer safety as well as liquidity. If your cash reserves are thin, Whipple says you can compensate by shoring up investments in liquid assets, such as money market funds or mutual funds.
Whether you have other sources of reliable income will determine how much you should have in liquid investments, says Ken Moraif, a certified financial planner and senior advisor at Dallas-based Money Matters. “If you’re living on your investments, you should have one to two years of your cost of living in cash,” he says. If you’re still working and drawing a salary, you can get by with a six-month store of cash so that “unusual nonrecurring expenses don’t cause you to sell investments at an inopportune time.”
Keep emotions out of the picture. Emotions can kill investment success, driving you to buy or refrain from buying at the worst times. “During market highs, people have a fear of missing out and want to invest more, which is precisely the wrong time to be buying in,” Herd says. When markets are down, people are too afraid to invest at the lower values, which is the ideal time to invest. Dollar-cost averaging, or investing equal amounts at regular intervals, can help investors steer clear of these traps.
[See: 13 Ways to Take the Emotions Out of Investing.]
A clear process for decision-making also prevents emotional choices during a market high, Whipple says. A sound investment decision requires knowing two things: what you need your money to do for you and all the critical facts about an investment before you invest. “Your decision to buy, hold or sell should adhere to those goals, and most of the time, it will take the emotion out of the decision-making process,” Whipple says.
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How to Ride Out a Market Peak originally appeared on usnews.com
