What Scared Investors Should Do Now

With most major market benchmarks hitting multiyear highs, many investors are starting to feel downright giddy. But if you're one to follow Warren Buffett's advice, you might be wondering whether it's time to be fearful while everyone else is being greedy.

Often, it makes sense to cut back on your stock exposure after a long bull run. But all the uncertainty about whether stocks are still cheap presents a new challenge on the question of whether to take profits. Fortunately, there's a simple move that scared investors can make to reduce their risk over time without making any abrupt changes that they may come to regret.

Keeping it simple
If you're like many investors, most of your returns come not from picking individual stocks but rather from the broad mix of asset classes that you invest in. Many workers with employer-sponsored 401(k) retirement plans aren't even allowed to pick individual stock investments, instead having to make the best of whatever set of mutual funds your employer picked for the plan. Even those who can pick whatever investments they want often choose to accept the simplicity and accessibility that mutual funds and exchange-traded funds offer.

To stick with an asset allocation strategy, it's important to rebalance your portfolio occasionally to make sure the risk level in your portfolio doesn't get out of whack. For instance, during the bull market that ended in late 2007 and early 2008, many investors simply rode their stock market winners up, even as those winners became an increasingly large percentage of their overall holdings. Only once the bottom fell out of the market did they realize that they'd put far more of their nest eggs at risk than they'd realized. Rebalancing helps prevent exactly that catastrophe from happening.

When rebalancing isn't the answer
Right now, however, figuring out the right investing strategy is particularly complicated. On one hand, the broader stock market has doubled in just the past three years. On the other hand, if you go back four or five years, stocks are still well below their peak levels -- despite overall earnings that are actually higher than they were back then.

So if you think your overall allocation to stocks is correct, is there still a way to cut back on risk? The answer is a resounding yes -- especially if you're still in a position to add new cash to your investment portfolio.

Buy low
Too many investors think of "the stock market" as a big mass of identical investments. Index funds have made investing easier for inexperienced savers, but they've also reinforced this idea that one stock is interchangeable with any other. In reality, though, the market is nothing more than an arbitrary grouping of companies -- some of which will perform very well, and others of which will eventually fail and cost their investors huge losses.

One way to manage your risk level without doing a full-fledged rebalancing is to move money within your stock allocation, from one set of stocks to another. By selling out a set of high-risk stocks and replacing it with lower-risk ones, you can build yourself a safer portfolio.

Take an example. Utility stocks are typically seen as low-risk propositions. But lately, industry leaders Duke Energy (NYSE: DUK  ) and Southern (NYSE: SO  ) have ridden a huge wave higher, as investors seek out their high dividends. Moreover, low natural gas prices have made electrical generation cheaper than ever. That confluence of positive factors has pushed share prices up -- and high valuations are riskier for investors.

To reduce risk, you might cut utility exposure in favor of companies in a beaten-down sector. Materials stock Freeport-McMoRan Copper & Gold (NYSE: FCX  ) and global steelmaker ArcelorMittal (NYSE: MT  ) took losses in 2011 as many questioned the staying power of the strength in emerging-market economies. Yet the same trends that could hurt utilities would help the materials sector -- and so bolstering your materials exposure could cancel out the risk involved in your utilities holdings.

Ease in
The gentle way to make shifts like this is simply to allocate any new money you invest to your favored sector. That way, you don't have to sell a thing -- and although it can take time for your allocation to reach your target risk level, it also keeps you disciplined to stick with your broader investing strategy.

If you haven't rebalanced your portfolio in a long time, doing so as stocks hit multiyear highs makes a lot of sense. But the simple strategy of putting your new money toward areas that have more promise can help you reduce your portfolio's overall risk without a lot of hassle.

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Fool contributor Dan Caplinger isn't a scaredy-cat investor. You can follow him on Twitter here. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of ArcelorMittal and Freeport-McMoRan Copper & Gold. Motley Fool newsletter services have recommended buying shares of Southern. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy helps you face your fear.

Read/Post Comments (5) | Recommend This Article (12)

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  • Report this Comment On February 28, 2012, at 11:00 AM, sikiliza wrote:

    "On the other hand, if you go back four or five years, stocks are still well below their peak levels"

    In behavioral finance, this statement would be interpreted as anchoring. In light of current economic upheavals in Europe, uncertainty in the United States, an election year, high unemployment, the Fed's continued money printing etc, stocks are much higher than they should be.

  • Report this Comment On February 28, 2012, at 12:27 PM, TMFGalagan wrote:

    @sikiliza -

    I agree with the anchoring comment, but it works both ways. As I point out, some are anchoring to the March 2009 lows, while others anchor to highs. Only by seeing both sides can you come to some sort of reasonable middle-ground analysis, in my opinion.


    dan (TMF Galagan)

  • Report this Comment On February 28, 2012, at 7:00 PM, thunderboltnova wrote:

    Keep a shopping list on hand of your favorite companies and if the market tanks, buy buy buy.

    Only sell when you retire.

  • Report this Comment On February 29, 2012, at 7:32 AM, bossman5000 wrote:

    In real dollar terms, the market is still 1000 points off it's all-time high,

  • Report this Comment On February 29, 2012, at 11:38 AM, itskash wrote:

    Having a tough time wrapping my head around this:

    Escape the risk of utility stocks and buy commodities. I own Freeport, but I see much more downside there than anything security held in the XLU.

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10/26/2016 4:02 PM
DUK $78.77 Up +0.18 +0.23%
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FCX $10.58 Up +0.03 +0.28%
Freeport-McMoRan C… CAPS Rating: ****
MT $6.73 Up +0.01 +0.15%
ArcelorMittal CAPS Rating: ***
SO $50.97 Down +0.00 +0.00%
Southern Company CAPS Rating: ****