Greed and fear are undeniably the undoing of many investors. Greed causes the purchase of investments simply because they have gone up, the excess use of debt and the suspension of logic and common sense. Fear drives the avoidance of any risk whatsoever and the abandonment of potential growth. The combination of the two can lead to a nasty pattern of buying high and selling low.
In small doses, however, greed and fear are essential to successful investing. They allow us to take reasonable risks to pursue growth and keep us within our “comfort zone”. At the same time, the markets have a way of ruthlessly grabbing our attention when either emotion has taken control.
In these times of stock market volatility, falling interest rates, potential inflation and possible recession (sounds pretty scary, doesn’t it?), here are some ways to protect a portfolio while not allowing fear to rule and unnecessarily hunkering down.
Go on Defense – Conventional wisdom holds that there are some areas in which consumers will continue to spend even in a slowdown. These “nondiscretionary” areas include health care, utilities and basics such as food, beverages, personal products and even tobacco. Except for health care, these are also “value” sectors which pay decent dividends and reflect the fundamental strengths of the business rather than some high rate of projected growth, so they tend to fall less when the market declines.
Fly to Quality – With uncertainty lurking everywhere, it may be wise to roll back the risk in your portfolio. This means avoiding high yield (or junk) bonds and historically volatile areas such as small company stocks and emerging markets in favor of high-quality corporate or Treasury bonds, large company stocks and developed foreign economies. Those risky areas often generate the highest returns, with emerging markets the most recent example, but they are also subject to unanticipated risk and sudden, steep declines.
Good TIPS – If inflation is a concern, consider Treasury Inflation-Protected Securities (TIPS). Like other Treasuries, an inflation-indexed security pays interest every six months and pays the principal when the security matures. The difference is that the coupon payments and underlying principal are automatically increased to compensate for inflation as measured by the consumer price index (CPI). In return for protecting your purchasing power, TIPS offer lower total returns.
Grow a Hedge – While the arcane world of hedge funds is no place for most individual investors, there are mutual funds known as “long-short” funds which strive to deliver investment gains in any market conditions. These funds combine traditional stock investments with “short” positions that will profit if the stocks fall, and may employ options and other hedging techniques. In positive markets, these funds will tread water, but their goal is to do well in declining markets. For the truly pessimistic, there are also pure “bear” funds which perform inversely to their underlying market. A bear fund, however, will deliver negative returns if the market unexpectedly recovers.
Build a Ladder – Even high quality bonds involve reinvestment risk, the risk that the proceeds of the maturing bond will have to be reinvested at then-current and potentially low interest rates. This risk can be minimized by breaking the bond portfolio evenly among bonds or CD’s that mature at regular intervals. When a bond matures, the proceeds can be reinvested to extend the ladder farther into the future. These staggered maturities have the added benefit of making cash available at regular intervals to meet unexpected needs without having to sell an investment in a potentially unfavorable market.
The Good Earth – Commodities, typically meaning energy, agricultural products and precious metals, often move independently from stocks and are also considered a hedge against inflation. Oil and gold have gotten most of the attention lately, but as with any investment further diversification through a broad commodity index will reduce risk. Traditionally the stocks of companies involved in the production of commodities was the most common way to invest in commodities, but there are many new exchange-traded funds (ETF’s) which offer commodity exposure more directly through futures contracts and other techniques. In addition to commodities prices already being relatively high, beware of some unique risks. Commodity-company stocks can rise and fall with the overall stock market regardless of the underlying commodity price, and some commodity ETF’s have unfavorable tax consequences.
Cash is King – Cash is unfairly considered boring by many investors, but in times of uncertainty it serves an important role in reducing risk and, if generated by selling appreciated holdings, preserving gains. Cash avoids declines in credit quality for bonds and declines in stock markets and economies at the cost of erosion in purchasing power due to inflation over time. Indeed, the average U.S.-stock mutual fund held 7.3% of assets in cash at the end of 2007, the highest year-end figure since 2000, according to Morningstar Inc. Some stock funds have upwards of 20% of assets in cash as they seek to preserve principal and look to take advantage of buying opportunities in the declining market. Similar to a bond ladder, holding cash avoids pressure to sell in an unfavorable market should unexpected needs arise.
All of these techniques have their own set of risks which should be fully understood before investing. Still, it is ultimately more dangerous to the pursuit of long-term financial goals to be frozen by fear, and by making some adjustments the portfolio will still be in a position to benefit from the inevitable, and often unpredictable, recovery.