After some really bad days for stock markets, it’s really important to focus on how to protect your portfolio from a bear market (or from days where everything seems to fall apart). What strategy to follow? How to plan ahead? How to protect us from our (wrong) predictions about the future of stock markets?
As I’ve wrote in another post, I believe that is very unlikely to see a major crash – without a relatively short rebound immediately after. Why? Because there is a lot of liquidity (thanks central banks) in the system. So with very low returns on safe deposits and bonds, investors are “forced” to look into other investments. It is inevitable. How can we fight the system?
Lets focus on the facts. That graphic above is from Dow Jones Index:
- 26/01/2018: DJI had over 26,600 points
- 05/02/2018: After a huge fall, it hit approximately 24,000 points
- 07/02/2018: Recovered to 25,000 points
- Also the VelocityShares Daily Inverse VIX Short-Term ETN, will be shut down, due to the NAV of the ETN crashed to $4.22 in one day, from $108.36. #oops
In my opinion there is a certain artificial environment created by central banks. On the other hand, making predictions about stock markets is always hard and often wrong. So read any prediction / outlook about the future of markets with a “grain of salt“. Yes including the ones that you read here.
I usually like to think on how markets will perform on the short and long run. What I’ve learn is this: The majority of people (including me) do not know what the market will do next. And that’s OK. We shouldn’t focus to much on return (because we can’t control it).
Plus for you to successfully anticipate stock markets, you must be right two times: On the outcome, and on the moment where that outcome will happen. And that’s almost impossible to achieve on the long run (think years / decades).
I keep reminding me of the following words of wisdom attributed to the economist John Maynard Keynes: The market can remain irrational longer than you can remain solvent.
Volatility VS Risk
- Volatility: is the dispersion of returns for a given security or market index, i.e., the amount of uncertainty of an asset.
- Risk: is the possibility of losing some or all of the original investment.
So a good strategy to protect your portfolio is for you to:
- Reduce the global volatility of your portfolio, and;
- Avoid risk.
All this while trying to achieve a good return on your investment.
How to Protect Your Portfolio
As you probably noticed, I’m a big fan of passive investment strategy. Building wealth slow and steady. Keeping the course. Minimizing costs. (That you can control!).
One effective strategy:
- Building a portfolio with different asset classes (Stocks, Bonds, Real Estate, Commodities, and so on)
- Picking low-cost ETFs (with the minimum Total Expense Ratio (TER) possible)
- Preferring high Assets Under Management (AuM) – less likely to close
- Liquid ETFs (easier to buy and/or sell)
- Plan the % to each asset (example: 60% Stocks + 40% Bonds)
- Rebalance periodically or when a % of a certain asset gets too high (that way you make yourself sell when the price is high and buy others when the price is low)
Even in a bear market we can see the effect of diversifying into at least 2 asset classes. Look at the following example:
- Portfolio (60% Stocks and 40% Bonds)
- 100% Stocks
For this example I used the SPDR S&P 500 Index (SPY) for stocks, and iShares Core Total US Bond (AGG) for bonds.
As you can see the total return (including all dividends), for the period of Jan 16, 2018 until Feb 09, 2018 – where the markets were really turbulent – you had a negative return, but was less negative when you added 40% bonds. Plus you cut the volatility almost in half. Believe me it is a lot more easy to follow a strategy when there is less volatility.
This is why I prefer a diversified portfolio. It will not get outstanding results on the short term. But it is expected to give you decent returns with a lot less volatility. Therefore the investor is less likely to panic and to sell it all in the worst possible time.
Looking at the same portfolios (60/40 VS 100% Stocks), in 2008 with a major bear market, how was the return?
With a 60%/40% portfolio you had:
- Half of the negative return. Therefore more easier to endure and to recover;
- Half of the volatility;
- At the peak of the bear market (only 2008) with 100% SPY you were losing 47% of your money. With the mixed portfolio 28%. A lot less pain.
To sum up having the discipline to include other assets, such as quality bonds, on your portfolio makes you a lot more resilient to bear markets, or to really bad days. You will give up some top returns (with top volatility and/or risk), but in return you will have less stress in your life.
For me the secret for a successful long term investment is having a decent return, while minimizing risk and volatility. And that’s all we want for an early retirement and financial independence, right?
How about you reader? What’s your favorite asset allocation?