With the pressures of the pandemic, job insecurity, the escalating U.S.-China rivalry, and a growing probability of an uncertain close to the fall elections, it might be a good idea to schedule a stress test. I mean for your investment portfolio.
Seriously, just how would your portfolio hold up under the pressure of a market sell-off of 20%, interest rates spiking, a conflict in the South China Sea or political paralysis in Washington?
You also need to factor in where the markets sit right now.
While continued and increasingly broad recovery in markets is very possible with interest rates so low and the powerful twin stimulus of the Fed and Federal spending, this is somewhat offset by historically high valuations.
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Remember, the unexpected can and will happen. The trick is not only preventing the unexpected to hammer your portfolio but instead serve as a springboard for big gains. My advice is not to hide from uncertainty – expect and embrace it and it will make you stronger. This is the theme of Nassim Nicholas Taleb’s book, Antifragile: Things That Gain from Disorder.
Here is one way Taleb aptly puts it:
“It’s far easier to figure out if something is fragile than to predict the occurrence of probability of it being fragile. Anything that has more upside than downside from random events is what is anti-fragile; the reverse is fragile.”
How can we apply this to our investment portfolios? First, don’t let big selloffs ruin your nest egg and, then, be ready to turn a downturn to your advantage. Here are a few ideas that may help.
4 Ways to Fortify Your Investment Portfolio
Always Take Some Profits Off the Table
In short, while staying the course and remaining optimistic is always the goal, it is always a good idea from time to time to take partial profits off the table.
This is a personal decision based on your personality and financial situation but a good rule for many might be to sell a third of a position if it doubles and let the remainder run.
The Golden Rule: Trailing Stop-Loss
We have all been there. You buy a stock or fund and it appreciates in value rapidly. Then it stumbles and begins to decline. What should you do? Buy more, let it ride, or sell?
Save yourself a lot of pain and agony by following a simple rule. If a position ever falls more than 25% from its high, sell it immediately and reassess the situation.
Some may counter that this 25% rule is a bit arbitrary but no doubt a 25% decline from a high is about as much as most investors can handle. This sort of decline indicates that the fundamentals have broken down. More risk-averse investors may want to have a tighter stop-loss policy set at 15% to 20%.
Hedge with an Inverse ETF or ETF Put Options
Here is another strategy to “stay calm and carry on” by using some portfolio shock absorbers to cushion the blow when markets inevitably turn against you.
Many ETF investors are unaware that roughly 40% of ETFs have put options and many hedge funds use a small amount of put options on the S&P 500 (SPY) to hedge their stock portfolio.
Before jumping into options trading, you should consult with your financial advisor and do some research about the basics. You can keep it simple, like checkers, or get a bit more sophisticated, like chess.
And while it usually doesn’t pay to make calls on the direction of markets, you should be aware that there are many inverse ETFs that move opposite from markets. For example, if you had a very strong belief that emerging markets were significantly overvalued but for tax reasons didn’t want to sell, you could hedge your positions with a dash of ProShares Short MSCI Emerging Markets (EUM), which moves opposite the MSCI Emerging Markets index.
The point is not to go overboard with either of these strategies, but even a small allocation to an inverse ETF can cushion your investment portfolio from heavy losses.
Keep Some Powder Dry
Finally, many investors have a hard time holding meaningful amounts of cash in their portfolio. Cash has to be put to work for a portfolio to grow but if you are 100% invested in your equity portfolio how can you take advantage when the market hands you fire sale prices? Yes, taking some of these measures will be a drag on your portfolio returns in a major bull run, but having a sizable cash position ready to put to work is a good move in the long run.
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