Shares won't go up forever. Take these steps now, before it's too late.
In the aftermath of the financial crisis, shares have seemed like they could go up forever. But instead of falling back into the trap of being complacent about your investments, take this opportunity to make sure that your portfolio won't take the same hit it did last year if the bear market comes back.
High Expectations
Lately, we've seen a reversal in the way people are thinking about the economy. Rather than focusing on every single piece of negative news -- and there's still plenty of it -- investors appear to be looking toward a brighter future.
As prospects improve, even beaten-down, highly indebted companies like Yell Group (LSE: YELL) and Punch Taverns (LSE: PUB) have seen their share prices post huge gains.
The resulting optimism has allowed the recent market rally to continue beyond most people's wildest expectations. Yet last week's pullback in shares shows just how vulnerable the recovery is. Soon, investors won't be satisfied with the prospect of future prosperity -- they'll want to see concrete signs of a recovery now, and if they don't see those signs, then look out below.
Headwinds Coming?
One other reason investors are getting skittish is that some of the favourable conditions supporting share prices may start going away soon. For instance, the low interest rates we've seen throughout the financial crisis have given investors a big disincentive to keep money in low-risk assets like cash and gilts.
Yet over in the US, Federal Reserve governor Kevin Warsh said last week that the Fed might need to raise rates sooner and faster than it has following previous recessions. Interest rates in Australia were raised yesterday, from 3% to 3.25%, making it the first country in the G20 to raise rates since the credit bubble went 'pop'.
The UK may be in a slightly different position, but from a base rate of just 0.5%, the only way is up. It's just a matter of time.
The Next Steps For Right Now
Regardless of whether last week's decline was just another in a long series of small pullbacks or the beginning of a long-awaited correction, there are several things you should do now to make sure you're ready for whatever the future brings.
1. Get your risk right
Most investors seek to control risk while maximizing returns by spreading their money across different asset classes. The idea is that when one group of investments loses money, the others gain or hold their value, so that overall, your portfolio is much less vulnerable to losses than it would be if all your money were in just a single investment.
After a big stock market move, though, you may have a riskier portfolio than you did back in March. With the FTSE 100 having risen over 40% from its lows, a 50/50 asset allocation between shares and bonds back in March could be up to 60% in shares right now.
Moreover, if your portfolio includes shares like Barclays (LSE: BARC), Barratt Developments (LSE: BDEV), and Legal & General (LSE: LGEN), which have seen colossal returns from their lows, then it might be even further out of whack.
Now's a good time to look at your investments and see if they match up with your target allocations. If not, then rebalancing could prevent a surprise like the one many investors got during last year's stock market plunge.
2. Watch your dividend shares
Dividend shares can be a great way to protect your portfolio from downturns. But instead of just taking a company's dividend at face value, look deeper to see if changing economic conditions could jeopardise it.
For instance, some dividend payers, including BT Group (LSE: BT-A) and United Utilities (LSE: UU), carry substantial debt on their balance sheets. During the economic downturn, low interest rates made it easier for companies to cover that debt. However, if a company has to refinance at higher rates, then the business has to become more profitable in order to support its debt.
Right now, the dividends for both BT and United Utilities are not fully covered by their profits. It could be a warning sign for the future sustainability of the dividend. Although it's not a sign of an imminent dividend cut by itself, high debt and low dividend cover can push a company to the breaking point -- especially if the economy fails to behave.
Shares won't go up forever, but you can still take steps to protect your investments. By actively managing your investments, you can take action to reduce risk before the next big downturn hits.
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> This article was originally published on Fool.com. It has been updated by Bruce Jackson, who does not have an interest in any of the companies mentioned in this article.
