How to reduce risk in your portfolio right now, according to the pros

Published Sun, Aug 21 20228:28 PM EDT

Stocks have been on a rollercoaster ride this year, as a mix of recession fears, inflationary pressures and a slew of other macro risks roil markets. U.S. indexes have recently bounced back from lows hit earlier this year, but Wall Street is still debating whether markets have hit the bottom. "While the third quarter has started off with a bang for equity and fixed-income markets, we think risks remain high that both the S & P 500 Index and the Bloomberg U.S. Aggregate Bond Index might be down for the full year," Veronica Willis, investment strategy analyst at the Wells Fargo Investment Institute, said in a Aug. 15 note. Here's what investors can do to lower risks to their portfolios, according to the pros. Blend a 5-stock portfolio with an ETF "Concentrated" stock portfolios for many retail investors are common, but can be very high risk, according to Peter Garnry, Saxo Bank's head of equity strategy. He noted that a "typical" return investor often has a portfolios of just 3-5 stocks, in an effort to minimize transaction costs. "We show that by blending a 5-stock portfolio 50/50 with an ETF that tracks the broader equity market the risk is brought down considerably without sacrificing the long-term expected return," he said. Saxo Bank carried out a study in which it randomly selected five European stocks and examined these portfolios' returns 12 years after January 2010. "A considerable percentage of these 1,000 portfolios end up with a negative return over this 12.5 year period which in itself is remarkable, but the number of portfolios that end with extremely high total returns is also surprisingly high," Garnry wrote. "In other words, a 5-stock portfolio is a lottery ticket with an extreme variance in outcome." Add an ETF that tracks the pan-European Stoxx 600 index to the mix, however, and investors saw their risk reduced, the bank said. "The striking result is that the median expected return is not changed but total risk (both gains and losses) is reduced considerably," Garnry wrote. He added that the Sharpe Ratio improves 20% on average by adding an overall equity market component. This ratio is a measure of a stock's performance relative to its volatility, and calculates its return above and beyond the risk-free rate, adjusted for the risk of holding it. "So most retail investors can drastically improve their risk-adjusted returns by adding an ETF that tracks the overall equity market without sacrificing the expected return," Garnry concluded. Diversify your 60/40 portfolio Analysts have recently been beating down the traditional 60/40 portfolio, although some banks have defended the strategy. That portfolio — made up of 60% stocks and 40% bonds – sustained losses of around 16% in the first half of 2022, according to data from Wells Fargo. Historically, when stocks lose ground, bonds gain – but both have moved lower together this year. As such, there are some tweaks that can be made to this strategy to mitigate losses, Wells Fargo suggested. "As we witnessed this year, and in a few cases prior, sometimes stocks and bonds move together. That is where including allocations to other asset classes that do not move in tandem with either stocks or bonds can be useful," said Willis of Wells Fargo. "The inclusion of diversifiers, like commodities and hedge fund strategies, can be a useful tool in mitigating downside risk as these assets so not always move in the same direction as stocks or bonds," the bank added. To reduce risk and losses, investors could consider the following allocation, according to Wells Fargo: 55% stocks, 35% bonds, 5% commodities and 5% hedge funds. That mix reduces losses this year to date to 8.67%, as compared to 10.62% for a 60% allocation to stocks and 40% to bonds, it added. Consider real assets Goldman said in a recent report that real assets could be more important in an investment cycle where inflation is higher than the world is used to. An equal-weight allocation of real estate, infrastructure, gold and a broad commodity index has led to the best risk-adjusted performance in periods of high inflation, according to Goldman Sachs Research. Goldman added: "Instead of a tech startup that might not produce a profit until many years from now, investors are favoring companies that can already produce earnings and dividends." "Warehouses have been a popular investment as e-commerce accelerates. Demand for companies that make battery storage has grown amid an increasing focus on renewable energy infrastructure," the bank said.