While Stocks Trade Near Record Highs, Chances Are Your Portfolio Isn't Sufficiently Protected

Investors may find themselves enticed by the tech-fueled surge in stock prices, aiming for new highs, but it could be an opportune moment to reflect on the protective potential of diversification strategies.

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Both the S&P 500 and the Nasdaq Composite have witnessed nearly 10% gains in the year 2024, with all major indices setting fresh closing records in the previous week. Notably, the surge has been significantly fueled by the communications services and information technology sectors, which have seen respective increases of 16% and 13% this year.

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However, as Charles NeSmith, a certified financial planner and portfolio manager at Tobias Financial Advisors, warns, it's easy to become fixated on the mega-cap technology stocks, despite the fact that the Nasdaq experienced a substantial 30% decline in 2022. This underscores the importance of diversification, particularly as certain companies amass market share, attracting investors eager for high returns.

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Diversification, as exemplified by the iShares Core Growth Allocation ETF (AOR), offers exposure to asset classes beyond equities, which can help mitigate the impact of stock market downturns. Despite experiencing a -15% total return in 2022 due to falling bond prices amid rising interest rates, AOR still outperformed the S&P 500, which recorded a -18% total return.

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Research from Morningstar highlights the increasing correlation between all-stock benchmarks and alternative asset classes like high-yield bonds over the past two decades. Over the long term, assets such as U.S. Treasurys and agency mortgage bonds have proven to be effective portfolio diversifiers, particularly during times of market volatility.

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Mortgage-backed securities, in particular, offer investors a means of diversification within their portfolios. Andrew Herzog, CFP and associate wealth advisor at The Watchman Group, suggests incorporating these securities alongside short-term Treasurys to balance risk and returns.

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Exchange-traded funds (ETFs) like the iShares MBS ETF (MBB) and Vanguard's MBS ETF (VMBS) offer accessible avenues for investors seeking exposure to mortgage-backed securities, with minimal expense ratios.

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Cash has also emerged as a valuable diversification tool, exhibiting the lowest correlation with stocks over the past three years. Money market funds provide a safe haven for investors seeking stability, with attractive yields available through indexes such as the Crane 100 Money Fund Index.

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Moreover, sectors such as utilities and energy have historically demonstrated distinct performance trends compared to the broader U.S. market, offering further diversification opportunities within equities. Similarly, commodities serve as effective hedges against inflation and display low correlations with other asset classes.

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Looking beyond domestic equities, diversifying across international markets can provide additional protection against downturns in the U.S. stock market. Emerging markets, in particular, offer attractive valuation opportunities compared to domestic counterparts and have shown lower correlations with U.S. equities over time.

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ETFs like the Vanguard FTSE Emerging Markets ETF (VWO) and the iShares Core MSCI Emerging Markets ETF (IEMG) offer investors exposure to emerging markets with competitive expense ratios and favorable year-to-date total returns. These international diversification strategies contribute to a well-rounded investment approach, enhancing portfolio resilience in the face of market volatility.

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