Investor Spring Cleaning - 2011

Call it what you will, cyclical bull market or secular bear market, there's no denying that the last two years have been good to Wall Street.

Fueled by better-than-expected corporate earnings and aggressive steps by the Federal Reserve to pump more money into the economy, the S&P Index has nearly doubled from its bear market bottom of March 2009. The Dow Industrials have also surged back.

For many investors, though, the wounds inflicted by the two most recent bear markets — the dot-com collapse in 2000 and the financial crisis seven years later — have permanently altered their appetite for risk.

Some still sit on the sidelines, mere spectators of the current rally, while others are letting their emotions dictate their equity positions.

What they should be doing instead is revisit their asset allocation to determine whether it still fits their financial profileand rebalance as needed to insulate against future market dips.

In light of the rapid recovery of the stock market it is extremely important for investors to look again at asset allocations for two main reasons. First, the growth of all asset classes has not been equal, which causes riskier assets to outpace safer investments. This growth causes portfolios to unintentionally drift toward a more aggressive position.

Secondly, the “mathematical underpinning” of valuation in all asset classes has changed dramatically: “Just because you liked certain assets at their unbelievable low valuations in March of 2009, does not mean you like them equally today.”

Given the state of geopolitical instability worldwide, however, and growing economic threats domestically, building a bulletproof portfolio these days takes more than stocks, bonds and cash.

In order to be considered diversified, an investor must now include alternatives in their portfolio.

The traditional asset classes that help make a portfolio more conservative, including bonds and cash, have excess risk at this time due to inflationary pressures that have already shown signs of working their way into our economy. Due to this fact, bonds and cash should be minimized in favor of alternatives and dividend-producing stocks.

With too much “easy money” in the system, a function of the Federal Reserve’s series of quantitative easing, signs of inflation are already working their way into the system, and interest rates are likely to rise over the next two to three years, putting bond holders in a position to lose money.

Christine Benz, director of personal finance for fund tracker Morningstar, agrees inflation is a wild card.

Because rising interest rates often accompany higher-than-average inflation, she says, investors should be cautious about venturing into long-duration bonds and bond funds.

“Investors should therefore consider building their positions over a period of several months rather than adding exposure in one fell swoop,” she says.

Historically, exposure to emerging markets like Latin America and developing Asia has also served as an effective inflation hedge, since those countries tend to be heavy on basic-materials producers, and are beneficiaries of higher demand and prices.

Getting Pickier About Stocks

While investors should generally be diversified across all stock sectors, those looking for short term tactical moves, according to Schwab’s latest Sector Views report, should consider energy stocks which will continue to benefit from increased global demand and a regulatory environment in Washington that could improve with the new congressional mix.

Despite its outperform rating, though, Schwab suggests “investors who racked up nice profits during the past month look to take some off the table as a near-term pullback is certainly possible.”

Schwab also gives the information technology sector a rating of “outperform.”

With large cash balances, increasing dividend payments, solid management and tight inventory controls, the tech sector is far more stable than it was in the late 1990s environment that so many still remember. “We believe those who remain invested in tech will be rewarded with outperformance in the coming months.”

Over the short term, financials are also expected to benefit from increased business loan demand, merger and acquisition activity, and the continued wide interest rate spread.

And while the firm acknowledges the challenges facing utilities, it notes that sector too remains “somewhat attractive” as investors search for areas of the market that pay a bit more in dividends.

“We’re still bullish on the U.S., particularly large cap stocks,” says Schwab. “There’s a very accommodating Fed policy right now for larger companies. Interest rates are low and able to really drive bottom line profits and earnings expectations, and we think that’s going to continue” for the near term.

Europe, particularly Spain, Portugal, Italy and Ireland, merits caution, he says; Germany is still “absolutely” on his investment radar screen.

For the non-equity portion of its balanced growth portfolio, the remaining 30 percent should be allocated to bonds, 5 percent to cash, and 11 percent to alternative investments like real estate investment trusts and commodities.

For tactical investors, commodities have been hard to ignore, posting some impressive gains over the last year, led by oil and gold.

Selecting an asset allocation that’s appropriate for you will not only serve to minimize risk in your overall portfolio, but also help you achieve your long-term financial goals.

Perhaps the biggest benefit, though, is that it gives you the intestinal fortitude to stay the course when the bottom falls out of the market. And it will happen again.

http://www.cnbc.com/id/41855090//