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Playing Defense: 11 Ways to Help Reduce Risk in Your Portfolio

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

Case in point: the market correction at the end of last year, which resulted in the first negative full-year return for the S&P 500® Index in a decade. “People who kept their stock allocations unchanged may have inadvertently taken on more risk than they realized as the stock market climbed year after year,” says Anthony Davidow, CIMA®, vice president and alternative beta and asset allocation strategist at the Schwab Center for Financial Research. “In fact, if you weren’t regularly rebalancing, you may have found out the hard way that you were overexposed to equities at the expense of other asset classes.”

With many analysts forecasting a slowdown in the global economy, now may be the time to rebalance your portfolio—and 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.

1. Reassess

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 two to four years’ worth of spending needs (after accounting for other sources of income, including Social Security). 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.

2. Rebalance

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. A portfolio that began in 2009 with 60% equities and 40% fixed income, for example, would have shifted to roughly 79% equities and 21% fixed income 10 years later, if left unchecked.1 “That means not only less diversification but also greater risk and volatility,” Tony says, “all without the investor ever consciously changing strategy.”

3. Remain calm

By all means, reassess and rebalance, but don’t forget to stay calm while doing so. “That head-for-the-exits feeling isn’t defense—it’s panic,” says Tony.

If such feelings are 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.

“It’s not about timing the market; it’s about time in the market,” Tony says. “In fact, our research shows that even bad market timing beats sitting on the sidelines” (see “Get in, stay in,” below).

 

Get in, stay in

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

Source: Schwab Center for Financial Research. Investors A & C put their yearly contributions in T-bills while waiting to invest in the stock market. The stock market is represented by the S&P 500 Index with all dividends reinvested. Past performance is no guarantee of future results.

 

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: Tony says he keeps at least 5% of his portfolio in cash for the diversification benefit, even when markets are climbing steadily. “Generally speaking, your upside with cash is limited, but it retains its value in the face of even the steepest market declines,” he says. That said, the three-month Treasury bill, a form of cash investment, delivered better returns in 2018 than both 10-year Treasuries and the S&P 500 Index.2
  • Consumer staples, health care and utilities: When the economy slows, companies that sell products most people need regardless of the state of the economy—think food, prescription drugs and other household necessities—tend to lose less value than those that produce nonessential products. “Even if you cut back during tough times, you’re still going to need laundry detergent,” says Brad Sorensen, managing director of market and sector analysis at the Schwab Center for Financial Research. Owning these and other so-called defensive stocks can be a good way to potentially capture at least some of the market’s gains while remaining relatively protected from its bigger swings.
  • 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) or intermediate-term Treasuries (which mature in less than 10 years) can provide decent income with low risk. Longer-term Treasuries may offer even more income, though their prices could take a hit if interest rates continue to rise.

Consider less:

  • Corporate and high-yield debt: The value of outstanding debt owed by businesses outside the financial sector has nearly doubled over the past decade, to a record $9.8 trillion,3 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. China, for example—the mother of all emerging markets—is growing its economy at its slowest pace in more than a decade, with ongoing trade tensions (as of publication) threatening to make matters worse.
  • 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.
  • Tech stocks: Large-cap technology stocks such as Apple, Alphabet and Microsoft led the market to new heights over the past decade, but when markets turned volatile in late 2018, these stocks fell fast. Apple shares lost 31% in the fourth quarter of the year, for example, compared with a 14% drop for the S&P 500.

De-risking the right way

“There are a lot of ways to dial back the risk in your portfolio,” Tony says. “The trick 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,” Tony says.

1Schwab Center for Financial Research with data provided by Morningstar Direct. Equities are represented by the S&P 500 Index and fixed income is represented by the Bloomberg Barclays U.S. Aggregate Bond Index.

2Aswath Damodaran, “Annual Returns on Stock, T-Bonds and T-Bills: 1928–Current,” Stern School of Business at New York University.

3Bloomberg, as of fourth quarter 2018.

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Important Disclosures:

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.

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.

Small-cap funds 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.

The Bloomberg Barclays U.S. Aggregate Bond Index represents securities that are SEC registered, taxable, and dollar denominated. The index covers the U.S. investment grade fixed-rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities.

The S&P 500 Index is designed to measure the performance of 500 leading publicly traded companies from a broad range of industries.

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