Have you given your portfolio a “recession check”?
by Rachna Bijlani, CFP®
December 19, 2022
Portfolio management 101:
Assessing risk tolerance- Risk tolerance is a function of objective measures such as your financial goals, time horizon for each goal, liquidity needs, your tax situation and unique circumstances like your ability to save, high income, or low living expenses relative to your income.
Portfolio Construction- Constructing a well diversified portfolio driven by your risk tolerance, while aiming to maximize returns for your specified level of risk.
Portfolio Monitoring & Rebalancing- Tracking your portfolio returns & monitoring and rebalancing your portfolio due to drift in asset weightings from intended levels as a result of market movements or due to changes in your financial situation.
Besides all the above, tactical changes can be made to your portfolio based on changes in the economic, political, social and legislative environment. Strategic and tactical asset allocation and risk management are the cornerstones of active portfolio management.
With the federal reserve aggressively hiking interest rates, and reduction in government spending in an attempt to tame inflation, the big fear looming on everyone’s mind is the US entering a recessionary phase, an overall contraction in the economy. It is hard to predict how long a recession will actually last or when it might start, but the stock market is considered to be a leading economic indicator, generally leading the economic cycles by six to seven months. In times of such economic uncertainty, what should you do as an investor? Should you liquidate your entire portfolio and sit in cash until the dust settles or should you do nothing and just ride the wave and hope for the best? These are both extreme reactions and as an investment advisor, I wouldn’t recommend either of these actions. Unless you have a crystal ball that can gaze into the future, it's practically impossible to accurately time the markets on a consistent basis. On the other hand, leaving your investment strategy entirely to fate can wipe out fortunes. Instead of being a silent speculator in your own financial story and relying on Pearl Jam and scotch to do the heavy lifting during such uncertain and trying times, I’d recommend you give your investment portfolio a “recession check” to determine if you need to make any changes. The way to do that is by checking your portfolio’s asset allocation and risk statistics. Let’s dive deeper and see what specifics you should look into.
Stock sectors- Check to see your portfolio’s allocation in cyclical vs defensive stocks. Cyclical stock sectors such as consumer discretionary, hospitality, certain types of real estate, automotive, etc. are sensitive to economic conditions and generally don’t hold up well during recessions. Defensive sectors such as healthcare, consumer staples, utilities, etc tend to be more stable during economic downturns. Dividend paying stocks of defensive and mature companies with sound fundamentals can offer steady return potential even in declining markets. Besides that, certain sectors are historically known to perform better than others in inflationary environments such as the current one. Do your research and conduct due diligence before making changes to your asset allocation.
Geographic regions- Check the geographic allocation of your investments. Research worldwide leading economic indicators, GDP forecasts, factor in currency risk and other region specific risks to determine if your portfolio is optimally positioned to weather an economic slowdown. Different regions worldwide could possibly be in different phases of the economic cycle at any moment in time, so exploring opportunities internationally, while being fully cognizant of the associated risks could be a strategy worth exploring during a slowdown in one region.
Valuation multiples- The stock market, which is driven by the collective actions of individual investors witnesses a reduction in the risk appetite of investors during market downturns. Overall lower GDP can lead to lower personal income and lower savings rate for most investors. When investors have less money to save and invest, they seek optimal utilization of their resources versus being more risk tolerant or even risk seeking during up cycles. Investors wanting more stability and more bang for their buck during recessionary phases start seeking value instead of chasing growth. Portfolio multiples such as Price/Earnings and Price/Sales when compared against benchmark multiples can gauge the valuation of your holdings compared to the benchmark. Growth oriented portfolios generally have higher P/E multiples compared to value portfolios. Consult your investment advisor to assess and adjust your portfolio’s P/E to suit the economic environment.
Fixed income quality and duration- Bonds are usually less volatile than equities and can potentially provide diversification from equities, liquidity, capital preservation and inflation protection. Check the credit quality of your bond holdings. Investment grade bonds, rated Baa (by Moody’s) or BBB (by S&P and Fitch) and above are believed to have lower risk of default as compared to non-investment grade bonds.
Bond duration is a measure of the sensitivity of a bond’s price to changes in interest rates. In a tightening interest rate environment, lower duration bonds could potentially be less risky as compared to higher duration bonds. Check the overall fixed income allocation in your portfolio, paying extra attention to the credit quality and duration of your bond holdings.
Risk statistics- Look at historic data to compute the worst performance of your current asset allocation over different time frames, such as 3 months, 1 year, 3 years, etc. Although past performance can't predict future performance, doing so will give you some idea about the level of risk in the portfolio. Calculate your portfolio’s standard deviation, or variance from the mean returns. Compare this to this standard deviation of the equity index or benchmark best suited for your portfolio. Higher standard deviation equals increased volatility, equals increased anxiety and sleepless nights. Know your portfolio’s Beta, which is a measure of your portfolio’s sensitivity to the market as a whole or to your chosen benchmark. Higher Beta implies higher systematic risk. It is usually a good strategy to decrease your portfolio’s risk and opt for safer assets near the end of an economic boom and to increase the risk in your investment portfolio when you sense the end of a recession. Being defensive and focussing on capital preservation and risk reduction might prove to be an effective strategy during a recession.
Instead of making a new year’s resolution, let’s switch things up and make an end-of-the-year resolution this time. Resolve to give your investment portfolio a good check, diagnose the problem and consult your investment advisor to help fix it. Once that’s done, go ahead and take that well earned vacation to Maui. My bags are packed! Happy Holidays!!
Consult your financial advisor before making any changes to your portfolio.
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