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How Asset Allocation Can Help Protect Your Portfolio

Dec 18, 2017 3 min read Ilana Polyak

Key Takeaways

  • Match your asset allocation to your risk tolerance and time horizon.
  • Remember to periodically review and rebalance.
  • Consider cutting down on risk as retirement nears.

 

Newtonian physics is simple: What goes up must come down. The stock market is no different. After suffering an almost 50% drop from its high in 2007 to the low in 2009, the market has been on a tear ever since. The Standard & Poor's 500, for example, has more than tripled since its low point in March 2009.


It's no wonder some investors are jittery. This bull market is the second-longest on record since World War II; it's natural that many investors are wondering when the party will end.

 

 

As uncomfortable or even distressing as market downturns can be, they needn't upend your portfolio if you structure it well and have realistic expectations.


Timing isn't always everything

It's hard to know when a bear market — widely defined as a decline of at least 20% from the highs — will strike. Some investment experts argue the current bull market still has room to run. But given how long stocks have been rising, each passing day could make a downturn more likely. No one can say for sure if and exactly when the market will fall significantly. However, it's best to be prepared for the possibility.


A strategy to help defend against significant portfolio losses is a well-diversified portfolio with an asset allocation that matches your risk tolerance and time horizon. That may not take all the sting out of a severe decline. While asset allocation does not assure a profit or protect against a loss in declining market it can help you design a portfolio that matches your risk tolerance and time horizon, so you're in a better position to be able to ride out the declines and stay invested until the next upward move.


Asset allocation: an important investment decision

The exact mix of stocks, bonds and other types of investments you own plays a central role in determining your portfolio's performance.


Here's why: Different asset classes behave differently under varying market conditions. The circumstances that might make, say, large-cap technology stocks tank, could be ideal for high-yield bonds, and vice versa. In other words, when one type of investment zigs, another may zag.
 

Having lots of different asset classes, therefore, allows you to participate in these different market moves. By hedging your bets this way, your portfolio probably won't rise as much as a broad bull market, but it also is unlikely to fall as much as a broad bear market.


Is your asset allocation where it should be?

Because of the strong stock market returns over the past eight years, you might be sitting on a much more stock-heavy portfolio than you intended, meaning you've taken on more risk than you might realize. Perhaps you started out with a 60% stock/40% bond split, but now you are closer to 80% stocks and 20% bonds due to these market moves.


In order to get back to your intended asset allocation, you will need to rebalance from time to time. That might feel painful, because it essentially means pulling money out of winners in order to prop up laggards. But by rebalancing, is necessary to have a diversified portfolio.


Asset allocation is dynamic

Remember, asset allocation isn't a “set it and forget it" proposition. It will naturally change as your time horizon shrinks or your risk tolerance evolves. The younger you are, the more risk you are likely able to handle , because you have many years to recover from severe losses. But when retirement is around the corner, there isn't as much time to make up lost ground, so it could be a wise choice to move to a more conservative risk profile.

Revisit your asset allocation from time to time to ensure you've still got the appropriate level of risk for your age and time horizon.

Bear in mind that this rule of thumb doesn't apply to all investors. Some young investors, though they have decades ahead of them, may be naturally risk averse and may want a more conservative portfolio. Likewise, some risk-tolerant pre-retirees and even retirees may be perfectly willing to ride out the ups and downs.

 

What you can do next

It's impossible to predict when the next bear market will arrive. The right asset allocation can help you weather a downturn, as long as it matches your risk tolerance and helps you stay the course. Investing involves risk and it is possible to lose money when investing so have a realistic understanding of just how much risk you can stomach.

 

Ilana Polyak is a freelance writer who specializes in personal finance and the financial advisory industry. Her work has appeared in The New York Times, Barron's, Kiplinger's Personal Finance, Bloomberg BusinessWeek and CNBC.com.

 

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