By John Wasik
CHICAGO, November 12 (Reuters) - If the fiscal cliff triggers an economic slowdown, you need to prepare your portfolio by lowering its risk profile. Even if you think you're prepared, it's good to take a detailed look at what you own.
Classic modern portfolio theory holds that diversification among stocks, bonds, real estate and other asset classes will balance the tenuous relationship between risk and return.
When the stock market tumbles 2 percent in a single day - as it did on Nov. 7 - many pundits say that's a sign of things to come if Congress doesn't resolve the mother of all tax hikes by the end of the year.
The idea of tax increases and spending cuts amounting to $600 billion on Jan. 1 is enough to instill markets with uncertainty, one of the greatest enemies of investors. Yet you can lose money if you react to every sell-off by jumping out of the market, so it makes sense to do a portfolio risk profile at least once a year. This will help buffer your portfolio against uncertainty risk.
A portfolio profile examines how asset classes react to volatility over time. What a portfolio profile is not is a knee-jerk reaction that allows you to time the market. To use it efficiently, you need a better understanding of risk.
What varies as we approach another year with uncertainty is how risk increases at different times. Here are some ways to lower your risk profile:
1) Review your asset classes. The idea of having 60 percent U.S. stocks and 40 percent bonds became obsolete some time ago. The more asset classes you own, the more you can avoid time-sensitive risk as investments fall in and out of favor during shifting market cycles. For example, let's say you want to keep a stock allocation of 60 percent to 80 percent. To reduce risk from U.S. markets, consider raising your allocation in emerging markets across all categories. This means small-, medium- and large-cap foreign stocks in value and growth categories.
2) Curb time-sensitive volatility. While diversification is desirable, it won't always save you from market volatility. If the darkest fiscal cliff scenario were to occur, volatility may be a larger issue than exposure to U.S. stocks. If a fiscal cliff were to raise taxes and trigger a recession, you would want to dump assets that are more volatile during pullbacks, including emerging market stocks. It's good to have REITs (real estate investment trusts) and small company stocks as well in an overall mix, but when economies contract these are the most volatile assets - ranging from 35 percent to 28 percent volatility. TIPs (Treasury Inflation-Protected Securities), which I recommend for every portfolio, have a relatively low volatility of about 6 percent during expanding economies but nearly double that during recessions, according to data compiled from March 1997 through June 2012 by Research Affiliates, an investment management firm in Pasadena, California. Short-term bonds are a good place to go during periods of high volatility, with less than 2 percent volatility during a downturn. That's in addition to boosting your cash holdings.
3) Seek weaker asset correlation. Ideally, a diversified portfolio has a range of investments that don't move in lockstep - they are relatively uncorrelated - and that reduces overall portfolio risk. But that is less common during a downturn. Of the 16 asset classes studied by Research Affiliates, the average correlation was 0.48 with the Standard & Poor's 500-stock index, with 1.0 meaning they move in the same direction as blue chips. During expanding economies, that correlation drops to 0.39. But during recessions, it climbs to an uncomfortable 0.62. How do your various positions move in relation to one another when times are bad? You can reduce overall correlated U.S. market risk by shifting into bank loan funds, short-term bonds and money market funds.
4) Examine tax risk. Here is another scenario to consider: What if Congress raises the tax on dividends and capital gains from 15 percent (for most investors) to 20 percent or more? In that case, you might want to reconsider your asset allocation - for example, by moving dividend-producing and growth stocks into tax-deferred retirement accounts.
No matter which scenario you believe will occur, you will want to make periodic changes if you find yourself drifting off course. Rebalancing twice a year means you won't have to worry about calling your broker or adviser in a cold sweat during downturns. If you take action, you won't have to call your doctor for your nerves, either.