How Can You Minimize The Risk From Your Investments Coming Into a New Year?
When the market experiences turbulence or uncertainty, making changes to your portfolio can be tempting. Historically, however, investors who bail out during dips tend to lose much more than they gain.
If pulling out of the market isn't the answer, how can you reduce financial risk as you head into the new year?
Understanding Year-End Market Dynamics
While historical performance does not guarantee future activity, we know from history that markets tend to follow seasonal patterns. Some of these have become so predictable that investors have given them names.
The January Effect refers to the first few weeks in January when small-cap stocks often outperform large-cap stocks. Typically, this happens due to year-end tax loss selling.
The Summer Doldrums is the name for June, July, and August, when volume, volatility, and performance are all usually low. The doldrums often result from many traders and public policymakers taking vacations.
The Santa Claus Rally comes hot on the heels of the October Effect, which refers to the volatile winds that seem to plague the stock markets in early fall. The Santa Claus Rally happens when the market spikes in December and the first two days of January. Many observers believe the rally results from holiday spending, tax considerations, and investor sentiment.
Seasonal effects are real, but other factors, such as geopolitical events and macroeconomic trends, have a much more dynamic impact on the market overtime. However, understanding the trends contributing to these seasonal market dynamics can be essential for investors aiming to minimize risk.
The end of the year can be a good time for you and your wealth management professional to reevaluate your investment strategy.
How do you measure your portfolio's annual performance?
We all want our investments to do well, but what does "doing well" even mean?
Portfolio returns can be measured in several ways.
Annualized portfolio return: An annualized return looks at how much an investment earns each year over a defined period of time. A geometric average will show what you would make if your annual returns were compounded (which is often what occurs when money is left invested). An arithmetic average, often referred to as a simple return, does not take compounding into account.
Sharpe ratio: This formula mathematically expresses risk-adjusted relative returns. It shows the difference between realized returns and benchmarks. The Sharpe ratio overtime can be suitable for distinguishing between a lucky break and a wise investment decision.
Beta: Beta measures a single stock's volatility against the overall market.
Total return: Total return expresses the price changes in an asset and the income the asset generates. It can include interest, dividends, gains, and other distributions.
Absolute and relative performance: Absolute performance is what your portfolio returned over a given period. Relative performance is a comparison. It’s absolute performance weighed against a benchmark or overall market performance during the same period.
Rolling returns: rolling returns help evaluate a portfolio's performance during several historical periods.
Time Weighted Return (TWR): TWR uses a complex formula to measure an investment's return without considering timing or cash flow size.
Money Weighted Rate of Return (MWR): MWR measures an investment's return considering the timing and size of withdrawals and deposits.This return can be impacted depending on when money was added or taken out.
As you and your financial advisor evaluate your portfolio's performance, you may also ask yourself if your level of risk is higher than you want. How can you minimize the risk to your investments in 2024?
Diversification as Risk Mitigation
Reassessing asset allocation (the mix and type of investments you hold) can be a crucial step in minimizing risk. A well-diversified portfolio can act as a robust defense mechanism against market uncertainties. Investors should consider reviewing their current asset allocation and market conditions in light of their current financial circumstances and individual risk tolerance. They might find things have changed personally or economically that warrant a slight shift in their strategy. Adjusting allocations based on these assessments may help build a more resilient investment portfolio.
Geographic and sector diversification can be another critical component of risk management. Markets and sectors may react differently to various economic and geopolitical events. Diversifying investments across different geographic regions and sectors may provide a more balanced risk exposure. Investors should consider analyzing their current portfolio's geographical and sectoral concentrations and adjust to align with their risk management goals.
Integrating defensive assets, such as bonds or dividend-paying stocks, into a portfolio can provide stability during turbulent market periods. While these assets may not offer the same growth potential as higher-risk investments, they may offer a cushion during market downturns. Evaluating the current economic environment and adjusting the allocation of defensive assets can be a prudent strategy to help minimize overall portfolio risk.
Strategic Review of Investment Goals and Timelines
Year-end provides an opportune moment to reassess your financial goals. Revisiting your short-term and long-term objectives can help investors realign their investment strategies with their changing financial needs. This strategic review allows for a more personalized and goal-oriented approach to investment decision-making.
Time Horizon Considerations
Understanding the time horizon for each investment goal (the time between now and when you plan to accomplish the goal) can be crucial for effective risk management. Investors with shorter time horizons may prioritize capital preservation, while those with longer horizons may be more comfortable with higher-risk assets.
Many investment professionals recommend reassessing your timeline every 6-12 months. Aligning investment decisions with the appropriate time horizon can help ensure that your investments are structured to withstand market fluctuations without compromising overall financial goals .
Ask yourself questions such as:
When will I need money from these investments? How long do I need that money to last?
How much loss could my investment absorb without affecting my plans?
Do I have a long enough time horizon to ride out the routine ups and downs of the market?
Liquidity Planning
In financial planning, liquidity refers to the speed with which an asset can be sold without affecting its price. The most liquid asset of all is cash. Stocks, bonds, and mutual funds are all also highly liquid assets. Real estate is an example of a much less liquid asset.
Liquidity planning, or planning to have the cash you need, can be paramount when reviewing your investments, especially during year-end periods when many of us begin to consider and set goals for the new year. . Having sufficient cash reserves or efficiently liquidable assets can allow investors to navigate unforeseen circumstances without resorting to panic selling.
Evaluating liquidity needs and maintaining an appropriate cash buffer can contribute to a more resilient and adaptable investment strategy.
Monitoring and Reacting to Market Signals
Investors who take on more risk generally need to engage actively with market information. Evaluating technical analysis, economic indicators, and fundamental analysis can allow you to stay informed and make timely decisions in response to changing market conditions. Taking a proactive approach can be crucial for managing risk and optimizing investment outcomes in a dynamic financial environment.
Utilizing Technical Analysis
Some investors leverage technical analysis to help them identify potential market signals and trends. Analyzing price charts, moving averages, and other technical indicators may provide insights into market sentiment and possible reversals.
While technical analysis has limitations, incorporating it into decision-making may enhance an investor's ability to react promptly to changing market conditions.
Staying Informed on Economic Indicators
Monitoring vital economic indicators may also helf investors anticipate market movements. Indicators such as GDP growth, unemployment rates, and inflation can influence companies and investment decisions.
Investors trying to anticipate the market would likely need to stay informed about relevant economic data releases and understand how these indicators may impact different asset classes. Whether you proactively plan for or respond to economic signals, proactively doing so can contribute to a more informed, risk-aware investment approach.
Fundamental Analysis
For many, fundamental analysis remains a cornerstone of sound investment decisions. Evaluating the financial health and performance of companies or assets can provide a solid foundation for long-term investment success.
Investors generally want to review their holdings regularly, , considering earnings reports, debt levels, and management effectiveness. This meticulous analysis can enable investors to make informed decisions based on the fundamental strength of their investments.
Prudent Risk Mitigation Through Tactical Adjustments
Stop-Loss Orders
Implementing stop-loss orders can be a practical, tactical approach to limit potential losses. Setting predetermined price levels at which assets will be sold can help investors maintain discipline and avoid emotional decision-making during market downturns. Stop-loss orders do not guarantee protection against all market risks, but they can be valuable risk management tools.
Dollar-Cost Average in Volatile Markets
Implementing a dollar-cost averaging strategy, especially during periods of market volatility, may effectively mitigate the influence of short-term price fluctuations. This method involves making consistent contributions of a fixed amount at regular intervals. - essentially, it's what most individuals do via their 401k plan. They're making regular 401k contributions each and every pay period.
When prices are low, these investors acquire more shares; when prices are high, they invest the same amount but secure fewer shares. Over time, this approach smoothens the average cost per share, thereby reducing the potential adverse effects of market volatility when investing new money in the market.
Remain Disciplined During Market Noise
Maintaining discipline and a long-term perspective can be crucial, especially during heightened market noise. External factors such as media headlines, rumors, and short-term market fluctuations can induce emotional reactions. So, instead of reacting, investors with a well-thought-out strategy may choose to stay focused on their financial goals and rely on their chosen investment strategy, principles, and God to guide their decision-making during turbulent times.
Following a comprehensive, structured approach can help investors navigate the challenges of market and financial risks and foster a resilient investment portfolio.
All investing is subject to risk, including the possible loss of the money you invest. Diversification does not ensure a profit or protect against a loss.