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Diversification has been a cornerstone of responsible investing practices for decades, but may prove more important than ever in the midst of the ongoing stock bull market, experts say.
Analysts note that the stock market’s positive returns over the past few years have been largely driven by a few outperforming tech companies (1) that many believe are overvalued, but other patterns are emerging that could spell trouble for the average portfolio.
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This includes, as veteran Wall Street commentator Jim Paulsen noted this week, higher overall risk (and a serious lack of traditional risk aversion) across the indexes.
“Amid all the interest in AI, investors are increasingly allowing a degree of risk aversion to disappear from their portfolios,” Paulsen wrote in a July 2 (2) post on his Substack magazine, where he shares market insights gleaned from his 40-year career as a strategist.
“It is becoming clear that the S&P 500—and probably most portfolios—is becoming much riskier… (and) as risk aversion increases, the likelihood of disappointing results has increased.”
Unprecedented technological exhibition
The primary concern for the average investor is that even if you’re not the type to jump on the chip train or forego life insurance to invest in tech ETFs (3), the very nature of US indices now leaves you more vulnerable to the potential fallout from the AI bubble than you might imagine.
Many popular broad market index funds, such as those based on the S&P 500, are now about 40% tech-heavy (4). Alphabet (NASDAQ:GOOG), Amazon (NASDAQ:AMZN), Microsoft (NASDAQ:MSFT) and Meta (NASDAQ:META), all consistently ranked among S&P’s top 10 largest companies, are expected to invest a collective $700 billion in artificial intelligence (5), meaning you’re likely in the AI game whether you like it or not.
Investing in multiple ETFs won’t help either, since they all overlap (6). And even funds marketed as “international” are still heavily exposed to the US market and economy.
As Paulsen and other experts warned this year, most components of the market are “essentially failing,” opening up a widening gap between “new era” and “old era” stocks. These two types historically move in the same direction during market highs, even if a small number of them lead the way—but this year, tech stocks have surged to all-time highs not only in isolation, but while traditionally safe and resilient “defensive” stocks have suffered.
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These defensive stocks now make up about 17% of the S&P 500’s total market capitalization, close to the all-time low of half its peak in the early 1990s, Paulsen wrote, warning that “with (defensive stocks) now making up such a small share of the capitalization, expect sharper market swings during the balance of this bull market.”
Read more: Are you paying too much for car insurance? Here are 3 smart ways to cut your monthly bill.
How to Become More Defensive
If you don’t want to rely too heavily on the AI boom, you can diversify with funds or individual stocks in critical non-tech sectors such as healthcare, consumer staples and regulated utilities. There are also generalist funds that are less technical (7), while international markets, if investments are active and strategically chosen (8), can provide greater protection and are often better priced, to boot.
Keep in mind that market segments such as real estate (especially data centers or office and retail REITs (9)), some industrial and materials industries (10), unregulated or nuclear utilities (8), and financial companies will be indirectly impacted by AI. That said, in these segments, precious metals like gold and silver, residential or self-sustained REITs (11), and cash-generating physical real estate, depending on interest rates, may help you take a more defensive position, as can some value stocks (8)—just do your research.
Ensuring you have a maximum of 25% invested in any given sector and a maximum of 5% in any given position is generally accepted best practice (6) for responsible diversification, as is moving between 15% (12) and 20% of your exposure overseas (13).
The traditional 60/40 rule of splitting your assets between stocks and bonds has also been turned on its head in this new era: Some economists suggest (14) that if you are willing to take some risk in joining the AI party, you instead allocate 60% of your portfolio to AI-open markets and 40% to AI-protected investments.
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Article sources
We rely only on verified sources and credible third-party reports. For details see our ethics and guidelines.
CNBC (1); Substack (2); Market House (3); Reuters (4); Yahoo Finance Canada (5); Guardfolio (6); Barrons (7); Schroeders (8); Urban lands (9); Oliver Wyman (10); In search of Alpha (11); Saxon (12); Avant-garde investor (13); Yahoo Finance (14)
This article originally appeared on Moneywise.com with the title: “Portfolios are getting a lot riskier”: How to make defensive investments before the AI bubble bursts.
This article provides information only and should not be construed as advice. It is provided without any warranty.