Over the past decade, investors have experienced historically low levels of volatility. This is largely due to the unprecedented fiscal intervention employed by the Federal Reserve following the Great Recession. Essentially, the Fed flooded the capital markets with immense amounts of liquidity and kept the fed funds rate near zero for about 10 years.
The resulting environment – which was widely seen as unsustainable – was great for borrowers and equity investors, but extremely challenging for savers and fixed income investors. The Fed launched a short rate normalization campaign in 2017, but the COVID-19 pandemic prompted it to retrace its steps, bringing its benchmark rate back to zero where it remained for nearly two years.
Now faced with runaway inflation, the Fed has aggressively raised the federal funds rate to 3% and looks set to take it even higher. This dramatic increase had a pronounced ripple effect on loans of all types and terms. It also fueled high levels of stock market volatility and stoked widespread economic uncertainty, both of which were exacerbated by the war in Ukraine.
All of this is incredibly nerve-wracking for investors, which brings us to the purpose of this article – to highlight six tips you can use to create a conservative investment portfolio.
1. Establish a cash reserve
Investing is a smart way to build wealth. However, you should establish an adequate cash reserve before investing your money in assets that are exposed to price fluctuations, potential loss of capital and cash lock-ups.
If you’ve established a solid budget, eliminated any problematic debt (like credit cards and personal loans), and funded an emergency reserve amounting to at least six months of expenses, it’s time to focus on the investing and harnessing the power of compound interest. The sooner you can do this, the better it will be for your bottom line.
I believe the best place to put your cash reserve is in a high yield savings account. The most competitive institutions currently offer interest of 2.00% to 3.00%.
2. Determine your investment time horizon
The basis of any investment portfolio is an estimate of your time horizon, the time until you expect to draw on your primary investment and accrued income. The longer the time horizon, the greater your growth potential and the more risk you can comfortably assume. Conversely, the shorter the time horizon, the lower your growth potential and the less risk you can comfortably assume.
Generally, a time horizon of 10 years or less is considered short while a time horizon of more than 10 years is considered long.
3. Familiarize yourself with the main asset classes
Asset classes available to most investors include publicly traded stocks, publicly traded debt securities, commodities, annuities, and cash. We generally define the riskiness of these assets based on the price volatility they exhibit. By that standard, I’ve illustrated a breakdown of some of the least risky to riskiest asset classes below.
Assets towards the left end of the chart are most suitable for conservative investors. They emphasize capital preservation and income generation rather than growth.
It’s best to make sure you fully understand everything you’re investing your money in. This requires fundamental research on these readily available asset classes or, ideally, the help of a trusted financial advisor. If you need help but are cost-conscious, you can hire a knowledgeable family member or find a robo-advisor.
4. Establish a prudent asset allocation strategy
Once you’ve determined your investment horizon and familiarized yourself with the appropriate asset classes, it’s time to formulate an asset allocation strategy. It should reflect high liquidity and provide you with stability and a high level of income. Your cash reserve accomplishes the first objective; A healthy allocation to higher quality bonds can achieve the second and third objectives.
That said, don’t overlook the importance of building a growth component into your portfolio. The most prudent way to do this is to use large-cap defensive stocks, especially those in the utilities and consumer staples sectors. These stocks show resilience during economic downturns and generate reliable dividends.
5. Take advantage of effective investment vehicles
Buying individual investments is not an effective way to build a conservative investment portfolio. It’s too expensive, it takes time, and it’s unlikely to yield the optimal degree of diversification. Using low-cost fund-like investment vehicles, such as exchange-traded funds (ETFs) and mutual funds, is a much better approach.
Both of these vehicles can provide highly diversified access to an asset or group of assets, and both are sponsored by some of the largest and most reputable investment firms in the world. ETFs trade like stocks and are bought and sold throughout the day at fluctuating market prices, while open-end mutual fund transactions are made directly with the fund company at prices determined at the end of each trading day depending on the fund’s underlying assets.
Mutual funds can be actively or passively managed. Most ETFs are relatively inexpensive and passively managed, tracking well-known indexes such as the S&P 500 and the Nasdaq Composite.
6. Rebalance your portfolio
Be diligent in monitoring your portfolio and periodically rebalance your investments based on your strategic asset allocation. Assuming there is no inflow of cash, this means selling some of the best performing assets and buying more of the worst performing assets.
If you’re working with a robo-advisor or full-service financial advisor, there’s no need to rebalance. This task is part of their service offer and will be completed automatically according to the terms established at the beginning of your relationship.