Smart portfolio management is all about risk management, not market timing. Therefore, preparing your portfolio for a new bear market doesn’t mean jumping from stocks to cash, where you will miss out on the gains that come at the end of a bull market.
In fact, the smartest tactical moves to make when the market appears to be heading in a new direction only involve a few adjustments to balance the objectives of maximizing return and minimizing risk.
Fine-Tuning the ‘Core & Satellite’ Portfolio for the Next Bear
Of course, there is no one-size-fits-all portfolio of funds but the smartest variety share the same basic makeup.
Whether knowing it or not, most investors build portfolios that have a core and satellite structure, which is just as it sounds — one core holding that represents the largest percentage of the portfolio and several other funds, the satellites, that each have smaller allocation percentages.
The core is usually a large-cap index fund that tracks the S&P 500 Index or Russell 3000 and the satellite fund types may include foreign stocks, emerging-markets stocks, small-cap stock, investment-grade bonds, money market funds and maybe a few sectors for added diversity.
The best bear market portfolio will have the same structure. All that’s necessary to prepare for tougher times ahead is to reduce or eliminate the riskier fund types and increase exposure to or add fund types with lower relative risk. There are also alternative and riskier strategies, such as buying bear market funds, but we won’t cover that here.
Invest in This, Not That
To put it simply, our strategy is to keep the best and get rid of the worst. As the bull market matures, it’s a good idea to lock in some gains and reduce market risk. The first step is to identify and remove exposure to the riskiest fund types. Let’s look at some examples of fund categories that are commonly among the worst performers during a bear market.
Here is average performance by fund category in 2008, the most recent year containing a full bear market (for stocks, compare with a return of -37.0% on the S&P 500 that year and for bonds, compare with a gain of 5.2% on the Barclays Aggregate Bond Index):
- Average Diversified Emerging Markets Fund: -54.4%
- Average Foreign Large Blend Fund: -43.9%
- Average Technology Sector Fund: -45.3%
- Average Energy Sector Fund: -51.1%
- Average Consumer Cyclical Fund: -39.8%
- Average High-Yield (Junk) Bond Fund: -26.4%
- Average Long-term Bond Fund: -3.7%
These funds all underperformed the averages, so our bear market portfolio will not include any of the above. We’ll use a simple combination of a large-cap stock index fund, a small-cap index fund, an aggregate bond index fund, three defensive stock ETFs (healthcare, consumer staples, and utilities) and one gold fund.
Now on to what we will keep or add. Check out an example of a bear market, core and satellite portfolio with a solid combination of ETFs that can maximize return and minimize risk: