If we learned one investment lesson last year, it's that the stock market changes quickly. In 2018, equity markets saw major moves and investors were dizzy by the end of the year trying to sort it all out.
First, the S&P 500 gained 5% in January before falling off a cliff with December's 9% drop. Not to mention the large one-day swings we witnessed: On Feb. 5, 2018, the Dow lost 1,175 points, down 4.6%. Later, on Dec. 26, 2018, the Dow soared 1,086 points, up 4.98%. Today, the market is up a healthy amount as we start the new year.
Last year's fluctuation serves as proof that you need to make adjustments to your portfolio way before the market moves one way or the other. You don't want to be caught off guard in a market correction or left out when the Dow has a big day. Take inventory of your investments and consider these three tweaks to your portfolio for 2019.
Rebalancing involves getting your portfolio back in line with your desired mix of stocks and bonds. If you began with a portfolio of 60% stocks and 40% bonds and the stock market soars, by the end of the year, your 60% in stocks is more like 65%. This is a good thing, because of course you want your stocks to grow.
The flip side though, is that your portfolio now has more risk than you intially allocated. When the market tanks, a 65% stock portfolio will probably go down more than a 60% stock portfolio. Rebalancing means selling some of your stocks and buying bonds to achieve your ideal 60/40 stock/bond mix.
Determining when to rebalance is not easy. Some prefer to set aside a specific date each year to do this, like on their birthday, marriage anniversary or work anniversary. Others rebalance when a position exceeds a certain percentage -- say their stock allocation gets 5 or 10 percentage points higher than they prefer.
Some people do both: Once a year, they see which portfolio positions have become outsized and require a trimming. Either way, the key is to have a regular process of reviewing your positions to ensure your asset mix is still where you want it. I prefer to rebalance in the beginning of the year.
Some investors may not rebalance at all, instead opting to let their winners ride, so to speak. Those investors typically enjoy a higher risk tolerance, or threshold for pain if the market corrects.
This also means they boast the ability to resist selling when the going gets tough. The ideal mix of stocks to rebalance to depends on your risk tolerance -- that is, the amount of fluctuation you can withstand in your investment portfolio. If you turned sickly green in December watching your nest egg drop with the market, then you probably own too much in stocks. But if you shrugged it off and carried on with your life, then your mix of stocks may be suitable for you.
Now is a good time, before the next big drop like we saw in December, to ensure your mix of stocks is in line with where you want it and, if not, to rebalance.
2. Invest abroad
International stocks significantly underperformed U.S. stocks last year, but this year may be different for a variety of reasons.
One reason is that there may be more value abroad. U.S. stocks have had a tremendous run the past 10 years, and international stocks have lagged.
No trend lasts forever, however, and at some point, the trend may reverse. In the investing world, we call this "reversion to the mean" (RTM) and it's the phenomenon in which an asset's performance over time gravitates toward its long-term average. No stock or stock market will soar indefinitely; history tells us that at some point, growth tapers off and prices come back down to earth. Think about it: If one asset went up continuously every year, then everyone would only buy that one asset.
But markets don't work that way. Inevitably, someone decides to sell and invest somewhere else, where there is more perceived value or opportunity. Reversion to the mean is a powerful investing concept, and once you understand it, you can use it to your advantage to buy into underappreciated or out-of-favor investments like international stocks that have been ignored by U.S. investors.
There are a variety of ways to invest abroad, but buying an international mutual fund or an exchange-traded fund (ETF) is the easiest way get broad exposure to a wide mix of international stocks with geographic diversification.
One risk with investing abroad is the currency risk. You buy the mutual fund or ETF with U.S. dollars, and the fund manager converts those dollars to the local currency to buy the international stocks, and then convert it back to U.S. dollars when you want to cash in your fund shares.
The risk lies when the dollar rises relative to the local currency, and your international fund can't buy as many U.S. dollars when it converts back, losing you money on the currency exchange. One way to offset the currency risk is to buy a dollar-hedged mutual fund or ETF.
3. Tilt toward value
Stocks can usually be classified as growth or value stocks. Growth stocks are shares in companies that anticipate rapid overall growth and may not pay dividends, instead reinvesting available cash flow into research and development -- think technology companies. Value stocks are your more tried-and-true, brick-and-mortar, dividend-paying companies like banks and automakers.
In 2017, 2018, and so far this year, growth stocks have beaten value stocks in terms of performance. But in 2016, value stocks handily beat growth, suggesting the trend is ripe for reversal.
Given the outperformance of growth stocks to value stocks in the past two years and so far in 2019, it may be wise to take some of the profits from growth stocks and reinvest them in value stocks. True growth stocks may outperform value again this year, and you would give up on that gain if you sold growth now. But how long can this trend continue?
Remember the reversion to the mean. At some point, growth stocks will revert to their long-term averages, and investors will realize how cheap value stocks are and start to buy them.
The key is to do this before the trend takes off, meaning you have to buy value stocks now while they are out of favor. That may mean giving up some upside now if growth stocks continue to outperform, but it also means more opportunity if this is the start of value outperforming growth in the long-run.
You don't have to overhaul your portfolio to get out of growth and into value. Just make a slight tweak by using profits from growth stocks or by moving 1% to 5% of your large-cap stocks into value stocks. You can hunt for bargains in individual stocks or simply buy a large-cap value fund. An exchange-traded fund (ETF) will provide greater diversification across a number of value holdings.
Deciding how to tweak your portfolio
Assuming I was comfortable with my stock-to-bond mix, I might rebalance some profits from U.S. large-cap growth stocks by buying U.S. large-cap value and international stocks. If I felt like December was more volatility than I could stomach, I'd rebalance some from U.S. large-cap growth to even safer bonds.
When it comes to investing, Warren Buffett said it best: "Be fearful when others are greedy, and greedy when others are fearful." Being greedy when others are fearful means buying things that are out of favor, like international stocks and value stocks. That is how you make money over time. Keep your more of your money by rebalancing to your original mix of stocks and bonds, so as not to be too greedy.
Greed is good, as Michael Douglas said in the movie Wall Street, but there is another saying on Wall Street: "Bulls and bears make money, but pigs get slaughtered." Think tweaks, not wholesale bets. Good luck profiting in 2019.
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