Here are 5 changes I'm making to my clients' portfolios to lower risk.
Horrific things happened this weekend in Israel. The human toll is incredible, the videos and pictures are beyond belief. I’m not going to dwell on the specifics as they’re absolutely heartbreaking.
Rather than focusing on the heart-wrenching details, I’m to address the potential repercussions on the stock market and the broader economy.
Israel is currently in conflict with Hamas, raising concerns about a potential regional escalation. Here's a breakdown:
What We Know:
Hamas's attack on Israel resulted in significant casualties, marking the largest single-day loss of Jewish life since the of the Holocaust.
Israel has declared war on Hamas and is preparing for an imminent invasion of the Gaza Strip, including a full blockade.
Western countries, including the US, are showing their support for Israel. The US has dispatched the USS Gerald Ford, our most advanced aircraft carrier, to the eastern Mediterranean and promised further assistance.
The Israeli military is the strongest in the Middle East. They face a nasty, brutal fight in the Gaza Strip, as it is one of the most densely populated areas in the world. From a military perspective though, they should be successful, even if significant additional losses are expected.
What I Think:
Hamas's attack is likely Iran's attempt to disrupt the ongoing negotiations between Saudi Arabia, Israel, and the US. Iran perceives the potential normalization of relations between Saudi Arabia and Israel as an existential threat, threatening the balance of power in the Middle East.
Reports from The Wall Street Journal and BBC suggest Iran was involved in planning in the attack, possibly through their Quds Force.
This situation complicates matters for Saudi Arabia, potentially delaying its normalization of ties with Israel.
Iran's strong ties with Russia and China, especially its discounted oil trade with China and membership in the Shanghai Cooperation Organization, could escalate tensions if Israel directly confronts Iran. The current scenario somewhat mirrors the system of alliances that led to World War I.
What We Don’t Know:
There’s a lot that we don’t know. Here are the things I’ll be looking for over the next few days or weeks.
To what extent was Iran involved in the attack?
To what extent was Iran involved in the attack?
To what extent, if at all, will Israel target Iran directly?
Will Hezbollah enter the fight and open a second front?
Does Iran have plans to continue support of Hamas and Hezbollah, particularly with advisors, money, and material?
Would China support or defend Iran?
To what extent will the Israel / Hamas war affect the stock market?
What You Should Do:
If you ask my wife, I was only halfway present this weekend. Since I saw the first reports of the attacks, I’ve been running through various scenarios and looking at background information.
From that, I have 3 general steps for dealing with emerging situations in your portfolio.
Inhale deeply. This isn’t the time for rushed decisions or panic. If you’re don’t plan retiring or taking withdrawals from your investments for at least 7-10 years, you can stop right here.
Take stock of your current portfolio. Are the equities in your portfolio overweight international stocks, specifically Emerging Markets? How about Growth versus Value? On the bond side, are you taking excess risk? Do you have High Yield bonds or other investments on the riskier end of the bond spectrum? Look at duration, what is the overall duration of your bond portfolio?
Decide on the right allocation for you. Are you comfortable with where you are now? Have you rebalanced this year, as the market has moved upwards? Now is a good time to rebalance and reduce your risk. If you want to become more defense in your equity holdings, do it, but don’t make your decisions based on emotion.
How I’m Updating Client Portfolios for Israel, Hamas, & Potential Stock Market Impacts
The market has been strong this year, with the S&P up over 12% YTD and the Nasdaq up more than 25%, despite weakness in the underlying economy. The economy has chugged along but cracks are beginning to show. Inflation has stubbornly held on and consumers are feeling the hit from both inflation and higher interest rates. Speaking of interest rates, it’s becoming more apparent that higher rates will be with us for longer than initially expected.
Putting all this together, I’m making my portfolios more defensive. I’m doing this in five ways:
1. I dropped Emerging Markets funds from client portfolios. For a variety of reasons, I don’t believe China to be investable and China, via Hong Kong and Taiwan, account for more than 40% of most EM funds. I don’t think the upside is worth the risk. I’ve sold nearly all Emerging Market funds in my client portfolios.
2. I’m lowering the allocation to Growth stocks and growth funds. Growth has outperformed value this year, but that’s primarily due to multiple expansion, not because earnings have improved. With interest rates staying higher, growth stocks are facing some tough headwinds. (If you want to know why high interest rates affect growth stocks more, I break it down here.)I would prefer to take some of the chips off the table by reducing the allocation to the riskiest part of the portfolio.
3. I increased the allocation to Value stocks, particularly in the Energy sector. Value stocks are less exposed to interest rate risk, so I prefer them right now. They’re also more defensive as we near a potential recession. In the value space, I prefer the Energy, Healthcare, and Consumer Staples sectors. I’m not trying to hit home runs; I’m trying to protect my clients’ portfolios.
4. I’m reducing bond risk. Bonds are riskier than you might expect, especially in a rising rate environment (Here's a link to my podcast where I explain how bonds really work). I want bonds to be boring and reliably return 3-4%. If I can get a bit better than that, all the better, but again, I’m not swinging for the fences here. I’m happy with singles and doubles.I’m moving from longer dated bonds, high-yield bonds, and other riskier instruments to Treasuries with 1–5 year maturities. Again, this isn’t a move to hit home runs. I’m happy locking in reasonable real yields while staying away from the interest rate risk at the long end of the Treasury curve. There’s little reason to hold something like the AGG, with a yield similar to the 5-year Treasury, but longer duration (and higher interest rate risk.)
5. I’m tax-loss harvesting in taxable accounts. If market volatility increases, I’ll be aggressively harvesting losses to reduce taxable gains or to directly reduce taxable income, depending on the situation. This can be a major benefit during periods of major market moves.If you’re not familiar with Tax-Loss Harvesting, check out this video. It explains how TLH works and how it can save you money at tax time.
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