By John Wasik
CHICAGO, November 12 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
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
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.