Many stock market valuation metrics today, such as price to sales, price earnings and total market capitalization relative to gross domestic product, point to a relatively highly valued market. While not every stock in the market is overpriced, the broad market is looking expensive compared to historical valuations.
“Investors often struggle with how to respond to a highly valued market,” says Daniel Roe, CFP, Chief Investment Officer at Budros, Ruhlin & Roe, Inc. “Regardless of one’s personal portfolio strategy and allocation, we believe that investors should be taking less risk today than they were 12 and 24 months ago. We think there are some prudent steps investors can take in order to begin to reduce the risk in their portfolios.”
Smart Business spoke with Roe about risk-management strategies in today’s market.
What portfolio strategies are best in today’s market?
For any portfolio that has a known cash flow component required to be paid each year — a retirement income portfolio that requires cash for groceries and travel, foundations or endowments that need to meet grant needs, etc. — it’s recommended to hold a full two years’ worth of known cash withdrawals in a safe money market or bank cash account. While 12 months of need might be acceptable in ‘normal’ periods, it is appropriate to move to a full two years’ worth of withdrawals today.
Further, consider holding higher allocations in positions and strategies that tend to be more defensive and have less downside exposure. These could include opportunistic fund managers who are willing to hold cash, and are doing so currently. Some value-oriented fund managers are currently holding 25 to 35 percent in cash, given market levels. That’s not always the case, but this gives them an option on future opportunities.
One way to gauge how much market risk you have in your stock allocation is to figure out your stock portfolio’s market Beta. This is the number that estimates how sensitive your stocks are relative to the Standard & Poor’s 500 index, or some other broad market index. The Beta for the whole market is 1.0, so if your stock portfolio measures out at, say, 0.85, then you would likely experience 15 percent less decline should stocks fall. Likewise, if your Beta is 1.15, then your stocks would probably fall 15 percent more than the decline in the broad market.
How should valuations affect an investor’s overall stock and bond allocation?
Most institutional portfolios, like pension plans and foundations, have investment policy statements that help guide the big allocation decisions. For example, a portfolio strategy might call for a target allocation to stocks of 65 percent, but with the ability to be anywhere in the range of, say, 55 to 75 percent. This allows for valuations to impact the allocation, but does not allow speculation, such as moving to 100 percent stocks, or all the way to 100 percent cash. That would be market timing and not advisable.
Today, an investor could move to underweight their target equity allocations as it is a good idea to be sensitive to and conscientious about valuations. When valuations are low, it’s advisable to take more risk. But when valuations are stretched, it’s best to carry less.
What’s the biggest mistake an investor can make in today’s market?
The biggest mistake investors can make is to chase past performance, yet it happens all the time, in every market cycle. It’s encouraging that there are solid flows to overseas stocks this year where it seems there are some better opportunities to diversify and earn higher returns.
How long do you anticipate these conditions will exist in the market?
It’s tough to predict how long current conditions will persist. It’s important to remember that market volatility is a normal thing, but was largely absent for a few years through the end of 2014. At the moment, we are in the third-longest stretch in the past 50 years without a 15 percent market correction. That’s a pretty odd thing when compared to historical trends. Ten and 15 percent corrections should be viewed as normal and healthy for the markets as they can set the stage for the next round of gains.
Insights Wealth Management is brought to you by Budros, Ruhlin & Roe, Inc.
