Protection from the Unexpected
08/20/2004 12:00 am EST
"I'd like to talk about how investors can protect their portfolios against the unexpected," saysEd Finn, editor of Barron's and editor-in-chief of SmartMoney. "And I promise I will not tell you to bury your money in the backyard." Here, he offers an asset mix to protect your portfolio.
"Unfortunately, the headlines in recent days have talked more about terrorism in the US. I live and work in New York City, and 9/11 is fresh in my mind. Our offices for Barron's and the Wall Street Journal are across the street from what was the World Trade Center. If disaster should strike again-and I am not predicting that it will- we certainly aim to be better prepared. And what I hope to share with you today should help you to better prepare your portfolio for any such sudden, unexpected event.
"The first thing we often do when we are undertaking this type of study is look back at history. History doesn't always repeat, but it often rhymes, so you have to pay attention to it. If you look back at what happened with crises over the past 100 years, stocks immediately have fallen from 10% to 20% in many of the cases, including the outbreak of WWI, Germany invading France in 1940, the Korean War, the US bombing campaign in Cambodia, the Arab oil embargo, the resignation of Nixon, Iraq invading Kuwait, the Asian stock market crisis, and 9/11. In all those cases, you saw very rapid stock market declines. So how can you protect yourself against that kind of slide? Of course, you can hedge, by using options or futures. But I'd like to talk to you about portfolio mix.
"One obvious answer is bonds, particularly Treasuries. In almost all the crises circumstances of the past, Treasuries held their value. These crises events led to a flight to quality, and Treasuries were the beneficiaries. (It's important to note that at times of crises, corporate bonds are less of a hedge against disaster, as they are considered less secure than Treasuries.) Let's look at 9/11 as an example. In that case, stocks fell 14% almost immediately. But bonds gained 1% or 2%. So if you were 50-50 in bonds and stocks, you're overall portfolio would have been down about 6% instead of 15%.
"Can we do any better than that? One asset class that tends to shine during times of crisis is gold. For example, in the 9/11 instance, gold actually jumped 7%. If you take these three asset classes together and mix them, you would have to have-to stay even in a crises such as 9/11- a mix of 25% stocks, 25% bonds, and 50% gold. This is hypothetical and I'm not advocating that mix, by any means. My view is that in a balanced portfolio, gold should never represent more than 10% of the total. There have been 20-year periods when gold has not gone up in price. In my personal portfolio, I don't hold any gold investments.
"Meanwhile, if you look at the crises we have noted, over time, they recede. In fact, the 15% decline after 9/11 was erased after one month and the stock market went on to make new highs. And as stock prices go up in times of recovery such as that, gold prices go back down. The message I am sending is that if you are a long-term investor, you can have a prudent mix in your portfolio, you can sit for the long term and your stocks will recover, while some of your hedges such as gold, become less valuable. So if you're an optimist, like I am, you won't be holding heavy amounts of gold. In terms of mutual funds, any balanced fund that holds stocks and bonds is going to do better at times of disaster than one that holds only stocks. In addition, if you are worried about inflation, consider Treasury Inflation Protected Securities (TIPS) and real estate investment trusts (REITs). Those can be part of a mix, particularly if you are concerned about inflation.
"One fund we wrote about recently in Barron's is PIMCO All Asset Fund (PAALX ). This fund is not about protecting against disaster, but really more hedging against inflation. In this case, trying to beat inflation by 5% a year by investing in things such as TIPS, stocks, bonds, foreign, etc. I think more funds like this will be created and more investors will fashion their portfolios in a more sophisticated manner- not just to have more upside in the good times, but to also protect themselves against the downside in the bad times.
"I think that people need to keep the bulk of their money in stocks-even into retirement. Stocks in my mind-at the moment- are fairly valued to undervalued. One of the situations we are in now is that the uncertainty around the election is holding the market back. I think the election will be more about removing uncertainty. And when that uncertainty gets resolved, I see stock prices heading up. Stocks do represent a value. Earnings are still growing. The rate might be slower, but I see earnings growing by at least 10% next year. The market could easily move up 10% before year-end and another 10% next year. Overall, I feel strongly that we can't go through life in a defensive crouch, worrying about the next thing that is going to befall us. I think that's important. Some prudent precautions are always wise. However, I choose to be an optimist about the country and the markets."