Ways to Help Reduce Risk in Your Portfolio

March 13, 2022
This game plan can help you play defense in turbulent times.

Sometimes it takes a stock market drop to get investors thinking about how to better protect their downside.

"An unattended portfolio may have become more aggressive as the stock portion outperformed the other asset classes and ended up accounting for more of the overall portfolio value," says Mark Riepe, managing director at the Schwab Center for Financial Research. "That's fine as long as stocks keep going up, but conditions can turn around quickly. When they do, you may not be prepared, either financially or emotionally, to tolerate a sharp decline in your portfolio."

To arm yourself against a potential market downturn, you may want to reexamine your investing strategy through the lens of your current risk appetite and time horizon.

Here are some basics to keep in mind about playing defense, along with specific tactics for managing risk during turbulent times.

Reassess your risk tolerance

Before you make any adjustments to your holdings, make sure your financial plan is up to date:

  • Does your portfolio mix still match your risk tolerance?
  • Does your risk tolerance still match your goals?

A spike in volatility can remind investors why it's often wise to take a more conservative stance the closer you get to retirement—by shifting from stocks into bonds and other fixed income investments, for example. Indeed, those in or near retirement may want to keep enough cash on hand to cover a year's worth of spending needs (after accounting for other sources of income, including Social Security), and cash or short-term bonds for an additional one to three years' worth of spending needs. This degree of financial flexibility can help investors manage unforeseen expenses without having to liquidate stocks under less-than-ideal conditions.

On the flip side, if retirement is at a comfortable distance, you shouldn't be too spooked by swings in the market. You may have sufficient time—so long as you stay invested—to wait out a downturn and capture the longer-term gains that stocks have historically delivered.

Rebalance your portfolio

Your portfolio should match your appetite for risk. If the recent stock market volatility made you want to jump ship, you may consider revisiting your allocation. Equally important, you want to make sure your intended asset allocation matches your actual one. If it doesn't, consider rebalancing by selling overweight positions and buying underweight ones.

When you fail to rebalance as stocks climb, your equity allocation can become an ever-larger part of your portfolio.

Remain focused

By all means, reassess and rebalance, but don't forget to stay focused while doing so. Trying to dump investments when both the market and your confidence are dropping disregards the adage "buy low, sell high."

If the head-for-the-exits feeling is familiar, you may be the kind of investor who would benefit from a more conservative portfolio—as part of your long-term strategy, not as a response to a market upset.

At the end of the day, though, staying invested to support your goals can help you avoid making decisions in the heat of the moment. Our research shows that even bad market timing beats perpetually sitting on the sidelines.

Get in, stay in

Here's where five hypothetical investors who invested $2,000 a year would have ended up after 20 years.

Peter ended up with $138,044, Ashley with $127,506, Matthew with $124,248, Rosie with $112,292, and Larry with just $43,948 which is significantly less than the others.

Source: Schwab Center for Financial Research.

Each individual invested $2,000 annually in a hypothetical portfolio that tracks the S&P 500® Index from 2003-2022.The individual who never bought stocks invested in a hypothetical portfolio that tracks the lbbotson U.S. 30-day Treasury Bill Index. Past performance is no guarantee of future results. Indexes are unmanaged, do not incur fees or expenses, and cannot be invested in directly. The examples are hypothetical and provided for illustrative purposes only. They are not intended to represent a specific investment product, and investors may not achieve similar results. Dividends and interest are assumed to have been reinvested, and the examples do not reflect the effects of taxes, expenses, or fees. Had fees, expenses, or taxes been considered, returns would have been substantially lower. 

Moves you can make

If, after reassessing your plan and rebalancing your portfolio, you want to take an even more defensive stance, there are other minor adjustments you might make. Specifically, you could bump up your holdings of less-risky asset classes and trim your long-term allocation to riskier ones. For example:

Consider more:

  • Cash and cash investments: Generally speaking, your upside with cash is limited, but it retains its value (before inflation) in the face of even the steepest market declines. And cash tends not to move in lockstep with changes in the prices of other kinds of assets. "Cash is the ultimate defensive asset, and cash investments can benefit from rising interest rates when the Fed is in a hiking cycle," Mark says. "Plus, it's great way to hold an emergency fund."
  • Gold: The precious metal has a history of holding its value—and even rising—when other asset classes are under pressure. In fact, it was one of the few investments with positive returns during the worst days of the 2008–2009 financial crisis. Keep in mind, however, that while gold and other precious metals can shine when market conditions are uncertain, their prices can be volatile.
  • Treasuries: Backed by the full faith and credit of the U.S. government, these are the safest fixed income investments you can own. Short-term Treasuries (which mature in a year or less) can provide income with low risk, especially as the Federal Reserve is poised to raise interest rates more than once in the coming months. Treasuries that mature in the intermediate term (i.e., less than 10 years) and longer term may offer even more income, though their prices could suffer as interest rates move higher.

Consider less:

  • High-yield debt: The value of outstanding debt owed by sub-investment grade businesses has more than doubled since 2008 to a record $3 trillion1 as companies capitalized on historically low interest rates, raising concerns of a potential bubble.
  • Emerging-market stocks: Slowing growth in developing countries has helped stoke some of the recent market turmoil. For example, China—the mother of all emerging markets—has faced slowing growth rates even as its hardline approach to COVID shutdowns, regulatory crackdowns, and corporate debt crises have led to volatility in the markets.
  • Small-cap stocks: Publicly traded companies with a market capitalization ranging from roughly $300 million to $2 billion tend to be more volatile than their large-cap counterparts, particularly during a downturn.

De-risking the right way

There are a lot of ways to dial back the risk in your portfolio. The idea is to embrace these options in appropriate amounts.

For example, taking a more aggressive tactical approach might be right for investors with the inclination, time, and skills to watch the market closely. But if—like most investors—you're focused on the long term, one of the best ways to play defense is to maintain an asset allocation that matches your time horizon and risk tolerance.

If you do decide to add or trim exposure to certain asset classes, make sure you're doing so in response to your needs and goals—not because of short-term market gyrations. The goal is to follow a strategy you can live with through the ups and downs.

1S&P Global Market Intelligence, as of June 30, 2021. Total sub-investment grade debt as measured by the S&P/LSTA Leveraged Loan Index and the S&P U.S. High Yield Corporate Bond Index.

Diversification, rebalancing, and asset allocation strategies do not ensure a profit and cannot protect against losses in a declining market. Rebalancing may cause investors to incur transaction costs and, when rebalancing a nonretirement account, taxable events may be created that may affect your tax liability.

Investing involves risks, including loss of principal.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness, or reliability cannot be guaranteed.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

All market data shown above are for illustrative purposes only. Supporting documentation for any claims or statistical information is available upon request. 

Fixed-income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications, and other factors. Investing in emerging markets may accentuate these risks.

International investments involve additional risks, which include differences in financial accounting standards, currency fluctuations, geopolitical risk, foreign taxes and regulations, and the potential for illiquid markets. Investing in emerging markets may accentuate these risks. 

Commodity-related products, including futures, carry a high level of risk and are not suitable for all investors. Commodity-related products may be extremely volatile, may be illiquid, and can be significantly affected by underlying commodity prices, world events, import controls, worldwide competition, government regulations, and economic conditions, regardless of the length of time shares are held. 

Small-cap stocks are subject to greater volatility than those in other asset categories.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

Indexes are unmanaged, do not incur management fees, costs, and expenses and cannot be invested in directly. 

S&P 500® Index Measures the performance of 500 leading publicly traded U.S. companies from a broad range of industries. It is a float-adjusted market-capitalization weighted index.