Safe drivers always check their blind spots. So why not do the same with your portfolio?
Most of us have blind spots as investors. We let our investments drift from our target mix; we miss opportunities or hold losing investments too long; we fail to see risks that could blow our returns off course.
These tendencies are only human, of course. But your portfolio could suffer as a result, leaving you short of your retirement or income goals. "Investors tend to be their own worst enemy," says Brian Kazanchy, a financial adviser with RegentAtlantic in Morristown, N.J.
Here are some common investing pitfalls, along with potential risks and opportunities in the market today. As always, you should do your own research or consult an adviser before investing.
Blind Spot 1: Your portfolio has gone adrift and isn't tax efficient
U.S. stocks have climbed more than 23% this year, while the bond market has slumped around 2%. Consequently, your portfolio may now be heavily tilted toward stocks, making it a good time to rebalance back to your target mix.
"A disciplined rebalancing strategy is your best friend to avoid the mistake of buying high and selling low," says Kazanchy. Indeed, studies show that systematic rebalancing can boost returns by around one percentage point a year over a portfolio that isn't rebalanced.
If your target mix is 60% stocks and 40% bonds, you might need to trim your stock exposure and add to fixed-income. You should also make sure your investment mix and goals are still aligned. For example, you may need more bonds if you're a step closer to retirement and want more stable income.
For more ideas on how to set up your portfolio, see Why stocks are less risky than bonds.
Your portfolio may need some tax-related tweaks. Many investors are now harvesting tax losses — selling positions that have lost money to offset taxable gains. For example, if you have losses in funds that invest in emerging markets and long-term government bonds — two areas hit hard this year — you could sell them to claim the tax losses. You could also buy similar funds if you want to maintain your exposure to those areas, keeping your overall investment mix intact.
It's also important to locate investments in the most tax-efficient accounts. Investments like U.S. stocks or stock funds typically don't generate much ordinary income and should be held in a taxable account, says Kazanchy. Investments that generate lots of income — such as high-yield bonds or REITs — should be kept in a tax-deferred account like an IRA.
Blind Spot 2: You're taking too much interest-rate risk
What's the biggest threat to bonds these days? Rising interest rates, according to many experts.
Bond prices and rates move in opposite directions, and the bond market has slumped this year on fears that the Federal Reserve will start to taper its government bond purchases — now $85 billion a month — pushing market yields upwards.
No one knows the timing or scope of Fed tapering, or its precise impact on different parts of the bond market. Many experts think long-term bonds face the most risk. But short-term bonds could succumb as well; investors seeking safety have flooded into short-dated bonds, and they could stampede out, pressuring prices and total returns.
"We don't know when tapering will occur, but we know that the Fed's zero-interest-rate policy is not sustainable," says Tom Sowanick, chief investment officer of OmniVest Group, a financial adviser in Princeton, N.J. "When we have a change in Fed policy, it's going to create havoc in the fixed-income markets.
That doesn't mean you should avoid bonds, but you may want to prepare for rising rates by taking less interest-rate risk. Sowanick, for example, is avoiding Treasurys and most corporate bonds, which he thinks have minimal upside. Instead, he's emphasizing municipal bonds, which he says offer more attractive after-tax yields and total return potential.
Some top-rated national muni funds, according to Morningstar, include BMO Intermediate Tax-Free Fund (MITFX), Fidelity Intermediate Municipal Income Fund (FLTMX) and RidgeWorth Investment Grade Tax-Exempt Bond Fund (STTBX).
Key risks: The funds could lose money if interest rates rise sharply in a short time frame. It costs $49.95 to buy shares of the RidgeWorth fund on the Fidelity platform.
Other advisers like "unconstrained" bond funds which have the flexibility to invest almost anywhere in the bond world. Two funds that Kazanchy uses for clients are JPMorgan Strategic Income Opportunities Fund (JSOAX) and PIMCO Unconstrained Bond Fund (PUBDX).
Neither fund yields much — around 2% or less. But they hold plenty of cash and very short-term bonds, which should help their returns stay positive, he says.
Key risk: The funds could lose money if rates spike over a short period.
Blind Spot 3: You have a home-country bias
Most people stick with stocks in their own country, and for U.S. investors that has been a winning strategy the last few years.
Yet that "home country bias" can mean missing opportunities abroad. The U.S. only accounts for about a third of the world's economy. Other regions are growing faster and have markets that may be more attractive now, according to some investors and advisers.
"I don't think people have enough of their portfolios in foreign markets in general, and emerging markets in particular," Princeton economics professor emeritus Burton Malkiel told Morningstar recently.
Some financial advisers also like foreign stocks, both for their discounts to the U.S. and potential diversification benefits. Richard Buoncore, managing partner with MAI Wealth Advisors in Cleveland, suggests holding 30% in foreign stocks with an emphasis on emerging markets.
"We like emerging markets a lot more than in the past." He says. "We think valuations have gotten attractive."
For European exposure, Buoncore uses the SPDR Euro Stoxx 50 ETF (FEZ), which tracks an index of 50 large European stocks. The ETF yields 2.3% and has an expense ratio of 0.29%.
For emerging markets, he likes funds that invest in small and midsize companies that tend to benefit more from local growth than large commodity and technology firms that dominate the major indexes.
Two ETFs to consider: SPDR S&P Emerging Markets Small Cap ETF (EWX) and iShares MSCI Emerging Markets Small Cap Index Fund (EEMS). Expense ratios are below 0.7%, and annualized dividend yields are 2.3% and 3.9% respectively.
These ETFs can make sense for investors willing to accept a bit more volatility in exchange for potentially better exposure to emerging markets, says Morningstar analyst Patricia Oey. For an investor with a 60/40 portfolio, a target allocation to emerging markets would be 4.5% of their overall portfolio or 7.7% of the equity portion, she says.
Key risks: The ETFs are more volatile than broad U.S.-based stock funds and could decline for a number of reasons including weakness in domestic markets or local currencies.
Daren Fonda is Senior Writer and Investing Columnist with Fidelity Interactive Content Services, a provider of objective investing content on Fidelity.com. He does not own any of the securities mentioned in this article.