• Analyze Valuation Metrics. It’s normal to be concerned about bubbles in a market that is hitting new highs. But not all stocks have been soaring. Many companies hit by the pandemic are actually relatively cheap. To understand if stocks are expensive or cheap, try using valuation metrics like price-to-earnings, price-to-book, and price-to-sales ratios.
• Stay Diversified. Diversifying the stock portion of your portfolio by company size (like small or large), by style (like value or growth), and by sector (like healthcare or financials) can help reduce volatility in a portfolio.
• Rebalance Asset Allocation. Rebalancing can help keep your portfolio on track toward your goals.
Bubble-Wrap Your Portfolio
1. Analyze Valuation Metrics:
To understand if a stock, or the whole market, may be expensive you need more information than the price.
Thinking about certain valuation metrics can help. That could be comparing the price of the stock to its earnings, book value, or sales. Then compare that to historical averages or some other reference point. You can do this company by company, across sectors and industries, or across broader markets. And what if a company or sector does have a higher-than-average price-to-earnings ratio? A high valuation typically implies that future returns may be more modest than in the recent past. But more modest doesn’t necessarily mean a market correction. For example, it could mean that rather than experiencing 8% or 10% gains, returns could be closer to 4% or 6%. Of course, returns can be negative as well. There are thousands of stocks in the US stock market. So even if some stocks seem pricey, many others may be attractively priced.
2. Stay Diversified
It’s important to maintain a balance of asset classes (stocks, bonds, and cash) that align with your investment time horizon, goals, and tolerance for risk. Diversifying the stock portion of your portfolio by company size (like small or large), by style (like value or growth), and by sector (like healthcare or financials) can help reduce volatility in a portfolio. The potential benefit of this is that many investors can still experience enough growth to reach their financial goals. Yet at the same time they’re not beholden to the performance of just one part of the market, or one type of stock or one specific sector.
3. Rebalance Asset Allocation
Because some parts of the market often do better or worse than others, your mix of investments won’t always stay the same over time. Rebalancing back to your original asset mix or a new mix based on your financial needs, time frame, and goals, you can help ensure that the level of risk and growth potential of your portfolio stays appropriate for your situation.
A diversified portfolio does not assure a profit or protect against loss in a declining market.