Diversification Strategies for Various Markets

A diversified portfolio focused on long-term growth represents one of the most effective ways to achieve your investment objectives over time. Under certain market conditions, it may make sense to slightly modify your investment strategy to capitalize on opportunities. A qualified wealth manager can help you adapt your investment objectives as markets change while remaining true to your long-term investment objectives.

What Is Portfolio Diversification?

Portfolio diversification is a strategy that can potentially help manage investment volatility over time. A custom, diversified portfolio that’s in line with your financial objectives and focused on long-term growth can help improve your chances of achieving your financial goals. While remaining invested in your target portfolio is typically enough to support your long-term investment success, there are several investment strategies that are particularly effective in navigating certain market conditions.

Diversification Strategies for a Bull Market

When stocks are increasing in value during a bull market, it may be tempting to chase returns. However, it’s important to remain focused on your long-term investment approach. The following asset allocation strategies can help you maintain discipline during strong market performance.

Rebalance your portfolio

Rebalancing refers to the process of selling off a portion of your high-performing assets and reinvesting the proceeds in lower-performing assets. While this may seem counterintuitive, it’s an important risk management strategy, because it helps prevent your portfolio from drifting too far from its target allocation (which can result in overexposure to market risk).

Portfolio rebalancing is essential for maintaining your intended asset allocation. As different asset classes experience varying growth rates, allocation drift can cause your portfolio to become misaligned with your risk profile and financial objectives. Without regular rebalancing, your portfolio structure can become distorted, exposing you to unintended levels of risk.

For example, let’s say you work with your wealth manager to set a target asset allocation of 50% domestic stocks, 30% bonds and 20% international stocks. Over a five-year bull market period, your U.S. stock holdings grow significantly in value and now represent a 60% share of your overall portfolio, resulting in an allocation that’s no longer in line with your target allocation and risk tolerance. If the U.S. markets experience a significant correction, you could experience greater losses than if you had rebalanced to your target allocation.

Maintain liquid assets

During bull markets, it’s important to hold enough cash to cover any potential emergencies and capitalize on market opportunities to buy low during an inevitable market correction. Maintaining liquid assets provides financial flexibility and positions you to take advantage of lower valuations when market downturns occur, enabling you to deploy capital strategically during periods of market volatility.

Incorporate value stocks

While growth stocks typically experience the strongest performance during bull markets, maintaining an allocation to value stocks has helped smooth out overall portfolio volatility historically. Bull markets often present an opportunity to purchase value stocks in well-established companies that are trading at a discount to their intrinsic value. Value investing complements growth stock exposure and helps create a more balanced equity portfolio.

Diversification Strategies for a Bear Market

During falling markets, diversification has historically played an even more important role in reducing portfolio volatility.

Increase bond holdings

High-quality bonds can provide stability and income during periods of market volatility. During a bear market, it may make sense to increase your holdings in short-term and government bonds. Bond allocations serve as a defensive component of your portfolio, offering income stability while equities experience downturns. Fixed income securities, particularly treasury bonds, provide capital preservation benefits during market downturns.

Rebalance opportunistically

If you position your portfolio well with more than enough in high-quality bonds to cover your short- and intermediate-term expenses, you may be able to take advantage of a significant bear market by selling a portion of your bond portfolio in order to redeploy the funds into stocks while those are trading at a discount. It’s important to evaluate any opportunistic rebalance through the lens of your long-term financial plan to make sure you’re well positioned if the bear market continues for an extended period of time. Working with a fiduciary advisor like Creative Planning can give you peace of mind and help you make decisions like this on an ongoing basis.

Use dollar-cost averaging

Dollar-cost averaging refers to the process of investing money at regular intervals over a long period of time. This investment approach can help minimize the downside risk of making a single, large investment at an inopportune time. Bear markets represent an opportunity to continue purchasing stocks at a “discount” to their typical share price, allowing regular investors to pick up more shares when the price drops. By maintaining consistent investment contributions through various market cycles, you reduce the impact of market timing risk and benefit from purchasing shares at lower valuations.

Employ tax-loss harvesting

Using a tax-loss harvesting strategy, you would sell an investment that has declined in value in the short term and replace it with a highly correlated alternative. When done correctly, this strategy allows you to maintain your target risk profile and expected return while using up to $3,000 per year in investment losses to offset ordinary income. If you realize more than $3,000 of losses in a single year, you can carry over the excess amount to offset income in future years. Your realized investment loss can result in a tax deduction, and the tax savings can be reinvested to continue growing the value of your portfolio. This can be particularly valuable when done as a part of a direct indexing strategy.

There are some complexities associated with this strategy, including a “wash sale” rule that’s triggered when an investor sells at a loss and, within 30 days before or after the sale, buys back a “substantially identical” security. A qualified wealth manager can help you avoid potential pitfalls associated with your tax-loss harvesting strategy while fostering tax efficiency across your portfolio.

Add private investments

Adding private investments to one’s portfolio, such as private equity, private credit, private real estate and private infrastructure funds, has historically helped reduce the portfolio risk associated with public markets. Private investments tend to have much lower volatility than their public market counterparts, and they can serve as relatively non-correlated assets to add to the mix for further diversification.

Diversification Strategy for an Inflationary Environment

In a high-inflation environment, the following strategy can help protect your long-term purchasing power.

Focus on companies with pricing power

Companies that perform well in high-inflation environments are those that are able to pass along rising costs to consumers without negatively impacting the demand for their products. These companies are often found in the retail and consumer staples sectors. Businesses with strong pricing power can maintain profitability and shareholder value even as their input costs increase, making them valuable holdings during periods of rising inflation.

Work With a Qualified Wealth Manager

A great way to help ensure your investment portfolio is well positioned to weather market volatility and various economic conditions is to work with a qualified wealth manager to develop a custom portfolio that meets your needs. Fiduciary financial advisors are legally bound to act in your best interests, helping to ensure your portfolio strategy aligns with your financial goals and risk tolerance.

Your wealth management professional can help you with:

• Establishing your target asset allocation, based on your financial objectives and investment timeline

• Creating a diversified strategy that spans multiple asset classes and sectors

• Monitoring for portfolio drift and executing timely rebalancing decisions

• Implementing tax-efficient strategies like tax-loss harvesting

• Adjusting your asset mix as market conditions and your financial situation evolve

If you could use help making sure your investment portfolio is properly diversified, please schedule a call with a member of our team.