Several factors threaten the stock market rally, including earnings season, which looks to disappoint; Europe, which isn’t out of the debtor’s woods yet; the coming end to quantitative easing, the Fed’s bond-buying program; and the weakening economy, just to name of few. Here are three methodologies for reducing exposure and increasing flexibility within portfolios.
Sell a Percentage
Probably the simplest, most straight-forward, way to reduce market exposure is to sell a percentage of your portfolio. To accomplish this, you first need to decide what percentage you would like to sell. For long-term investors looking to remain mostly invested, a 20 percent reduction may make sense, while those looking to be a bit more tactical — looking to take advantage of a possible pull-back — may want to use a larger percentage.
The mechanics of selling a percentage of the overall portfolio start with calculating the chosen percentage by which you would like to reduce the portfolio of each position held. For example, if you’ve decided to reduce your exposure by 20 percent, and if you own individual stocks, mutual funds or ETFs, you would simply calculate 20 percent of each position held. This would give you the dollar amount of each position you would need to sell. You would then divide each dollar amount by the current share price to get the number of shares you would need to sell. It is often a good idea to round the number of shares to the closest 50- or 100-share lots, if possible. By following this procedure for each position held, you would end up with roughly a 20 percent reduction in exposure, or with 20 percent more cash.
Sector Weightings Approach
Investors who have built their portfolio with a focus on specific economic sectors may want to consider evaluating each sector individually, and then selecting a percentage reduction for each sector that will combine to reduce the overall portfolio by the desired percentage.
For example, if the desired overall percentage reduction is 20 percent and the total portfolio value is $1 million, the total reduction would be $200,000. The investor would want to evaluate each sector as weighted in the portfolio to select the appropriate dollar amount of reduction for that sector, with the ultimate goal of reducing total exposure by the $200,000. This investor might have a 30 percent weighting in technology, so he or she may want to take 30 percent of the $200,000, or $60,000, as the target reduction within technology holdings. Once this has been determined, the investors can then reduce their holdings in technology by $60,000.
The same process would be used for each of the remaining sectors until the total reduction of $200,000 has been achieved. The investor could then decide how best to allocate the $60,000 reduction among the positions held within the technology sector, and the amounts calculated for the remaining sectors as well.
Security Weightings Reduction Approach
The investor may want to evaluate each individual position held to determine the best way to reduce exposure. Often, when markets rally as they have recently, some positions perform better than others. This results in the individual weightings of positions changing, with some potentially becoming larger weightings than desired. For example, a stock that has risen dramatically could become a 10 percent weighting in the total portfolio, making its contribution to the total risk profile for the portfolio far too great. The investor in this situation may want to focus the risk-reduction strategy on reducing the weightings of individual securities that represent more than a 5 percent weighting the total portfolio. If the desired percentage reduction is again 20 percent, or $200,000 in our example, the investor can shoot for a total of $200,000 in reductions, and then allocate that $200,000 among the positions that represent more than a 5 percent weighting in the portfolio.
Often investors fear that a correction of significant magnitude is pending, but they don’t know how to go about reducing their risk. This typically results in a “deer in the headlights” response, meaning the investor does nothing. There a few things more frustrating for an investor than believing something is going to happen in the markets, but failing to do anything about it, only to be proven right and still lose money.
By following one of these methodologies, investors can approach a risk-reduction strategy in a systematic way, achieving not only a reduction in the risk within their portfolio, but also freeing up cash, which will then be available for repurchasing positions, once the correction has taken place. While there is certainly no guarantee that a correction is imminent, there are strong warning signs. A prudent risk-reduction strategy can provide investors with an effective game plan, and some piece of mind, as they navigate what looks to be a turbulent period for stocks to come.
— Craig Allen, CFA, CFP, CIMA, is president of Montecito Private Asset Management LLC and founder of Dump Your Debt. He has been managing assets for foundations, corporations and high-net worth individuals for more than 20 years and is a Chartered Financial Analyst (CFA charter holder), a Certified Financial Planner (CFP) and holds the Certified Investment Management Analyst (CIMA) certification. He blogs at Finance With Craig Allen and can be contacted at email@example.com or 805.898.1400. Click here to read previous columns or follow him on Twitter: @MPAMCraig. The opinions expressed are his own.