Fortify your portfolio against autumn market shocks
Stocks roared higher in a delayed relief rally on Thursday, following the Federal Reserve’s jumbo-sized interest rate cut Wednesday, but rocky times may be ahead – and investors will want to prepare for that volatility. Excitement over the central bank’s half-point rate cut lifted the S & P 500 over the 5,700 threshold for the first time ever on Thursday. However, Goldman Sachs warns that investors should buckle up for a potential bumpy ride in the market. “On average, over the past 30+ years, [the CBOE Volatility Index] has increased 6% from September to October, and we see upside risks to the current VIX levels given seasonality and upcoming macro/micro catalysts,” wrote analyst Arun Prakash in a Thursday report. Key catalysts that could shake up the markets include the third-quarters earnings that will be reported in October, the Nov. 5 general election and the final two Fed meetings of 2024, in November and December, Prakash’s team said. “Election years, especially leading up to the big vote in November, tend to be a little more volatile and this year has been no exception,” said Rafia Hasan, chief investment officer of San Francisco-based Perigon Wealth Management. Recalibrate for risk Protecting your portfolio from sharp losses begins with understanding your comfort with risk and ensuring that your asset allocation reflects your long-term goals. “Staying in your seat and keeping clients invested in those periods is very important, but so is structuring the portfolio in such a way that you recognize some clients might have a lower risk tolerance,” Hasan said. She has used a combination of tax loss harvesting and direct indexing – in which an investor’s portfolio holds individual stocks to mirror an index – to take advantage of shakier periods in the market. The benefit of direct indexing is that the investor can prune underlying stock holdings, whereas an index exchange traded fund acts as a whole basket of securities. By trimming falling positions, investors can harvest losses and use them to offset taxable capital gains elsewhere. To the extent losses exceed capital gains, investors can use them to offset up to $3,000 in ordinary income and carry forward losses above that for use in future years. “You saw this big drawdown on August 5, and after a couple of weeks the markets recovered,” Hasan said. “But over that period when markets were down, there were opportunities to harvest losses in stocks, individual names that experienced big pullbacks.” Clients replace the positions they’ve sold with stocks that are in the same sector and expected to perform similarly. The point is to avoid violating the wash sale rule: The IRS will disallow the loss if you buy a “substantially similar” security to the one you sold within 30 days before or after the sale. Bulk up on bonds Even as the Fed has lowered rates, bonds are still offering attractive yields – “more so than they did in the prior 10 years when rates were near zero,” Hasan said. And they’ve been a good buy for clients who are nearing retirement, seeking income and appreciate bonds’ ability to offset stocks’ volatility. For higher-income clients, she likes municipal bonds, which offer tax-exempt income on a federal level. Investors who reside in the issuing state may also receive income free of state or local taxes. In all, she has been adding some duration exposure – that is, bonds with greater price sensitivity to interest rate moves – aiming for five to seven years. Andrew Herzog, certified financial planner at The Watchman Group in Plano, Texas, has also been adding exposure to bonds with an eye on quality. “We’re willing to ignore the higher-yielding investments if we don’t feel they’re safe enough,” he said. Herzog has been aiming for roughly two- to five-years duration, and he’s been adding more exposure to the iShares 1-3 Year Treasury Bond ETF (SHY) . The fund has an expense ratio of 0.15% and a 30-day SEC yield of 3.74%. “Think of what a rate cut could do to fixed income” in terms of capital gains, he said. “Move a little of your wealth into something that could get a boost off of that.” Options for buffering losses Options are also playing a role in investors’ portfolios as financial advisors try to mitigate volatility. Covered calls are one way to tackle the problem. Call options give investors the right to buy a stock at a specified strike price before a certain date. Covered call strategies entail selling a call option when you already own the underlying security. The individual selling the call option benefits from premium income but must be ready to sell the stock – and potentially give up greater upside. A slate of so-called buffer ETFS, also known as “defined outcome ETFs,” are also putting options to work. These offerings generally combine long deep-in-the-money call options tied to a specific index and a long put spread to protect against losses up to a certain amount. Near-retirees who are concerned about shaky markets might be the prime candidates for these instruments. “One of my most important jobs is to manage the risk in the client’s portfolio, and these are great tools to do exactly that,” said Gregory Guenther, a retirement planner at GrantVest Financial Group in Matawan, New Jersey. He noted that the due diligence can be heavy lifting for individual investors: Buffer ETFs need to be purchased on a specific day and then held until the underlying options expire to provide the full benefit. In addition to understanding the timing element behind the purchase, investors also need to grasp the fees, which can run in the neighborhood of 0.75% to 0.85%, according to Morningstar. “The heavy lift is doing the research up front, making sure you get the best offering out there,” Guenther said. “Are you getting the highest cap available and the lowest internal fees?”
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