As of this writing, major U.S. stock market indexes are at or near record highs. This bullish run might continue…or it may come to an end with a significant correction. Below are several strategies to consider.
Stay the course
Many investors prefer to keep their current stock market positions. For nearly a century, every stock market reversal has been followed by a recovery. Even the severe shock of late 2008 through early 2009 has led to new peaks less than a decade later.
What’s more, holding onto stocks and stock funds won’t trigger income tax from capital gains that would result from profitable sales.
Move into cash
Investors who are truly nervous about the current bull market can sell some or all of those holdings and convert the proceeds into less risky assets, such as money market funds or certificates of deposit. This would reduce the risk of substantial losses from a sell-off. In both the 2000-2002 and the 2007-2009 bear markets, the S&P 500 Index of large-company stocks fell approximately 50%. After a loss of that magnitude, investors need a 100% rebound just to regain their portfolio’s value.
However, cash and cash equivalents currently have minimal yields due to historically low interest rates. As such, transitioning funds to this asset class may stunt the growth of a portfolio. Timing the market has proven to be next to impossible, so investors moving into cash risk missing out on future gains as well as potential losses. In addition, the sale of appreciated equities held in taxable accounts will most likely produce a tax liability from capital gains.
Move into bonds
Aside from cash, bonds have long been considered a lower risk counterweight to stocks. According to Morningstar’s Ibbotson subsidiary, large-company U.S. equities have suffered double-digit losses in five different calendar years since the 1970s. In 2008, for example, that loss was 37%.
Long-term government bonds, on the other hand, have had fewer down years. The only year they lost more than 9% was 2009, when a drop of 15% was reported. That 2009 loss, though, came after a 26% gain in 2008, following a stock market crash. Therefore, Treasury bonds can be an effective hedge against stock market losses.
Yields on the 10-year Treasury are currently around 2.6%, so long-term Treasury bond funds may pay roughly 2% after fees. While these returns are nothing to write home about, they are superior to those currently possible from cash and cash equivalents. Intermediate and short-term Treasury funds generally have lower yields but also less exposure to market volatility.
Investors in high tax states can also take advantage of tax-free income (at the state & local levels) offered by Treasury bonds if they are held in taxable accounts.
There are pros and cons to all of these strategies, so you should proceed with caution. In general, a buy and hold strategy may appeal to workers who are many years from retirement. Market drops may turn out to be a buying opportunity, especially if you are investing consistently through contributions to an employer-sponsored retirement plan (such as a 401(k), etc.). On the other hand, trimming stock holdings might be prudent if you are in or near retirement. A market skid can be particularly dangerous if you are tapping into your portfolio for spending money.
–Investments: Growing Net Worth Through Financial Securities