Protecting Your Portfolio
As you get closer to retirement, you'll want to take less risk but maintain solid growth. Here's how to tend your nest egg
What group might you lighten up on to shift more money into dividend payers? Well, stocks of small companies have had quite a run, and they typically pay out fewer dividends than the stocks of large companies. While the Russell 2000 index of small stocks sports a dividend yield of just 0.99 percent, the Russell 200 index of the nation's biggest companies pays out 1.95 percent, almost twice as much.
What's more, small companies have been on a tear for more than five years. While the Russell 2000 has returned 10.5 percent a year on average for the past five years, large stocks have delivered less than 0.5 percent. Even if small caps continue to run, there's still an argument to reduce one's stake in this group. Small stocks have historically been more volatile than shares of large companies. Consider: The worst three-month loss for the average small-cap fund was a drop of 25.5 percent, in the summer of 1998, according to Morningstar. The worst three-month loss for the Fidelity Dividend Growth fund was only 16.1 percent. Meanwhile, that fund's best three-month gain was nearly 22 percent, which almost matches the best three-month gain for small stocks.
Go abroad. Another risk-reducing option is to move beyond the U.S. border. The typical 401(k) investor has only 4.4 percent of his or her assets in international equities, according to a Hewitt Associates study. But foreign stocks, because they do not move in perfect lockstep with domestic issues, help diversify your portfolio.
While there is a 92 percent correlation between movements in large U.S. stocks and small-cap shares, there's only an 85 percent correlation between large U.S. and large foreign stocks, according to Morningstar. The correlation is even smaller between large U.S. stocks and foreign small company equities.
Financial planner Ron Roge says investors should consider putting around 20 percent of their portfolios in international securities. Foreign stocks are cheaper in general than domestic shares. The average holding in a U.S. small-cap growth fund, for instance, trades at a price-earnings ratio of nearly 24, while the typical European stock fund's average holding sports a P/E ratio of only 15.4. And Asian stocks are even cheaper.
Many believe that after a decade of U.S. stock dominance in the 1990s, foreign shares are likely to be a solid investment for years to come. GMO forecasts that international equities are likely to return around 1.3 percent a year, after inflation, for the next seven years. By comparison, large U.S. stocks are forecast to lose 1.4 percent annually in real terms. Of course, these are just estimates.
Avoid junk bonds. On the fixed-income side, investors aren't being paid much at all to take risks, so many bond experts say now is a good time to stick with treasury bonds and high-quality corporate securities. Lower-quality junk-bond funds have performed remarkably well in recent years, posting returns of nearly 12 percent a year over the past three years. But should the economy slow down considerably, the likelihood of junk-bond defaults would rise. And junk bonds often move in close correlation with stocks. So if your intent is to reduce equity risk in your portfolio, high-yield bond funds aren't the best choice.
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