Well, that's been enough excitement for one week, hasn't it?
In the space of seven days, we've seen a terrorist bombing, an industrial explosion, and flash floods. And, for good measure, the market has trended downward, with selling likely spurred by the unsettling news flow as well as a lackluster corporate earnings season.
Stocks rallied this past Friday, but before that the U.S. equity market was on track to log its worst week since June 2012. The Morningstar US Market Index had lost more than 3% in the one-week period through April 18, and the small- and mid-cap stock indexes dropped well more than 4% during that same time frame.
Losing money is never fun, and it's usually not a great idea to draw grand conclusions from an ultrashort time period that in hindsight could prove anomalous. That said, the recent market shock seems well-timed in that it can help investors understand and troubleshoot the risks that lurk in their portfolios at a time when many seem to be complacent about them. With stocks logging double-digit gains on an annualized basis during the past three years, it's probably no surprise that investors in aggregate seem to be in risk-on mode, finally warming up to stocks and embracing risky fixed-income assets such as high-yield and emerging-markets bonds, according to Morningstar's recent asset-flows data. Yet they're doing so at a time when many risky asset classes don't feature particularly compelling valuations, and their portfolios' risk exposures may have already appreciated beyond their targets for them.
If you're concerned about how much risk your portfolio is taking on, you can use the recent downturn as an impetus to check up on your portfolio's potential problem spots. To do so, focus on the following tasks.
Job 1: The Asset-Class Checkup
Even though stocks have recently stumbled, equity market appreciation has been such a powerful force since early 2009 that it's highly possible that your stock weighting has gone higher than your target. It's easy to get comfortable with a large equity stake when your investment statements roll in featuring ever-higher balances, but periodic downturns serve as a valuable reminder of the importance of setting out basic asset-allocation parameters and rebalancing back to them when they get out of whack. Rebalancing is particularly urgent if your equity weighting is more than 5 to 10 percentage points higher than your target allocation and you're within 10 to 15 years of retirement. True, bonds don't appear particularly compelling right now, with yields on high-quality, shorter-duration bonds [duration is a measure of interest-rate sensitivity] barely in positive territory. But your bonds aren't there so much to serve as a return engine as they are to provide ballast for the risky parts of your portfolio, and in this regard high-quality bonds should deliver. This article (http://news.morningstar.com/articlenet/article.aspx?id=592841) harnesses some guidance from noted financial-planning experts on how to go about rebalancing right now, and this one (http://news.morningstar.com/articlenet/article.aspx?id=592849) discusses how to set asset-allocation targets if you don't already have them.
Job 2: Aim for Sector Balance
The stocks that fared the worst during the recent downturn tend to cluster in sectors that Morningstar classifies as cyclical or at least economically sensitive, including financial services, industrials, and basic materials. Meanwhile, those that operate in more defensive sectors, such as consumer defensive and health care, held up relatively better. Morningstar's X-Ray tool serves as a valuable means of gauging your current sector exposures, depicting your portfolio's weightings alongside those of the S&P 500. You don't have to build a portfolio that's in lockstep with that index, but if your portfolio skews heavily toward economically sensitive or cyclical sectors at the expense of more defensive ones, that's an indication that its performance will depend on the strength of the economy, for better and for worse. A slight cyclical tilt is fine, but be sure you hold some more defensive names to serve as ballast when the economic news is gloomy.
Job 3: Conduct a Safety Check of Your Fixed-Income Holdings
One area where investors have arguably become the most complacent about risk-taking is in the realm of bonds. True, investors have been sending plenty of dollars into sensible-shoe bond categories like short- and intermediate-term bond funds, but they've also been snapping up funds in exotic groups like high-yield and emerging-markets bonds. Yields are higher in these noncore categories, to be sure, but so is the risk potential and the correlation with the equity market, as I argued in this article (http://news.morningstar.com/articlenet/article.aspx?id=541319). Morningstar's Future of Fixed Income Week (http://news.morningstar.com/articlenet/article.aspx?id=591435) featured many articles and videos about how to manage your fixed-income position so it's not fighting the last war; this article (http://news.morningstar.com/articlenet/article.aspx?id=592182) looks specifically at how to assess the risk factors that lurk within your bond portfolio today.
