Recently, we have seen many stories of investors seeing outsized stock returns being discussed on online forum Reddit. The large returns some investors in these stocks have achieved has attracted new investors. The challenge here is that the frenzy that builds around these stocks pushes prices well above any reasonable valuation of these companies’ shares based on their future profitability, making buying their stocks a speculative bet, rather than an investment decision. Some investors will make large gains, but eventually the stock price must fall to re-align with the company’s earning potential, making losers of the last investors to buy in before the fall. While these types of returns are always welcome, investor responses to them tend to lean in the wrong direction. This is because investors must always confront the strong human emotions of fear and greed. When stocks are declining, fear can take over causing investors to sell their stocks at exactly the wrong time, when they have gone down in value. When stocks have risen, greed takes hold leading investors to add more money to investments that often have already reached full value or even become overpriced. This fear of missing out tends to draw in new investors who chase returns only to see the bottom drop out of stock prices shortly after they invested.
The problem for speculators is in knowing the right time to sell to avoid giving back all their gains. Investors, who go into financial markets with an investment strategy that includes maintaining a diversified portfolio, have less of a challenge in this regard. Investors should view a run-up in stock prices as an opportunity to rebalance their portfolios, taking some of the stock market risk off the table. The problem is, when stocks keep rising, fear or missing out leads to reluctance to sell. Then there is the question of where to invest the sale proceeds. Bonds would be a logical landing place, but many investors are convinced that interest rates will see further increases which will push bond prices down. This leads to further rebalance reluctance. Source www.seacoastonline.com
David T. Mayes is a CERTIFIED FINANCIAL PLANNERTM professional and IRS Enrolled Agent at Three Bearings Fiduciary Advisors, Inc., a fee-only financial planning firm in Hampton. He can be reached at (603) 926-1775 or firstname.lastname@example.org.
When it comes to bond investments, however, the type of bond matters for achieving diversification benefits. These days, investors may be attracted to high-yield bonds because of the out-sized returns they can achieve and their higher income payments. The problem with this approach is that lower quality bond returns tend to be highly correlated with the stock market, so they do not provide the expected buoyancy when stocks are under water. Instead, investors should look to add to positions in US Treasury bonds rather than loading up on lower-quality corporate bonds. Despite relatively low yields, investors are likely to be well-served by rebalancing into their allocation to Treasury bonds, or adding an allocation to Treasuries, to maintain their desired risk level and be prepared for the next downturn. True, we can expect bonds to see lackluster returns if interest rates do keep rising, but that does not mean rebalancing a portfolio should be delayed if stock prices have run up enough to push an investor’s stock allocation beyond its initial target. Maintaining a diversified portfolio means maintaining exposure to assets whose returns show low or negative correlations. That is, they tend not to move in the same direction at the same time. This is the reason to combine a stock portfolio with bonds, not because bonds can be expected to provide high returns. When the economy goes into recession, stock prices will fall because investors expect companies to see much smaller profits, but bond prices tend to rise as many investors sell out of stocks in favor of the safety of bonds and the Federal Reserve moves in to reduce interest rates. Both these responses are a positive for bond prices and help a diversified investor offset some of their stock market losses.
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