How to reduce risk in your portfolio right now, according to the pros
Equities have had a rollercoaster ride this year as a mix of recession fears, inflationary pressures and a host of other macro risks rattled markets. US indices have recently rebounded from the lows hit earlier this year, but Wall Street is still debating whether markets have bottomed. “Although the third quarter started with a bang for equity and bond markets, we think the risks are high that both the S&P 500 Index and the Bloomberg US Aggregate Bond Index could be down for the full year,” Veronica said Willis, an investment strategy analyst at the Wells Fargo Investment Institute, said in an Aug. 15 note. Here’s what the pros say investors can do to lower the risk to their portfolios. Combine a 5-stock portfolio with an ETF ‘Concentrated’ equity portfolios are common for many retail investors but can carry a very high level of risk, says Peter Garnry, Saxo Bank’s head of equity strategy. He noted that a “typical” return investor often has a portfolio of just 3-5 stocks to minimize transaction costs. “We show that mixing a 5-stock portfolio 50/50 with an ETF that tracks the broader stock market significantly reduces risk without sacrificing long-term expected returns,” he said. Saxo Bank conducted a study in which they randomly selected five European stocks and examined the returns of these portfolios 12 years after January 2010, but the number of portfolios ending with extremely high total returns is also surprisingly high,” wrote garry. “In other words, a 5-stock portfolio is a lottery ticket with wildly different outcomes.” Add an ETF tracking the pan-European Stoxx 600 index to the mix, however, and investors saw their risk reduced, the bank said. “The striking result is that the mean expected return is not changed, but the overall risk (both gains and losses) is significantly reduced,” Garnry wrote. He added that adding a general stock market component improves the Sharpe ratio by 20% on average. This ratio is a measure of a stock’s performance relative to its volatility and calculates its return above the risk-free rate, adjusted for the risk of holding it. “So most retail investors can dramatically improve their risk-adjusted returns by adding an ETF that tracks the entire stock market without sacrificing expected returns,” Garnry concluded. Diversify your 60/40 portfolio Analysts have recently ditched the traditional 60/40 portfolio, although some banks have defended the strategy. That portfolio — made up of 60% stocks and 40% bonds — suffered losses of around 16% in the first half of 2022, according to data from Wells Fargo. Historically, bonds gain when stocks lose ground, but both have fallen together this year. As such, there are some tweaks that can be made to this strategy to mitigate losses, Wells Fargo suggested. “As we’ve seen this year and in some cases before, stocks and bonds sometimes move together. This is where it can be useful to include allocations to other asset classes that are not moving in line with stocks or bonds,” said Willis of Wells Fargo. “The inclusion of diversifiers such as commodities and hedge fund strategies can be a useful tool for mitigating downside risk as these assets do not always move in the same direction as stocks or bonds,” the bank added. To reduce risk and loss, investors could consider the following split, according to Wells Fargo: 55% stocks, 35% bonds, 5% commodities, and 5% hedge funds. That mix cuts losses to 8.67% year to date, compared to 10.62% with a 60% allocation to equities and 40% to bonds, she added. Consider real assets Goldman said in a recent report that real assets could be more important in an investment cycle where inflation is higher than the world is used to. An equally weighted allocation to real estate, infrastructure, gold and a broad commodity index has led to the best risk-adjusted performance in times of high inflation, according to Goldman Sachs Research. Goldman added, “Rather than a tech startup that may not be profitable for many years, investors prefer companies that can already generate profits and dividends.” “Warehouses are a popular investment as e-commerce accelerates. Demand for battery storage companies has increased amid an increasing focus on renewable energy infrastructure,” the bank said.