This article was first published by Kim Iskyan at Truewealth Publishing
Despite a cloud of gloom and uncertainty hanging over global markets this year, many of the world’s major stock markets have moved up. And that means that there’s no better time to take stock and check that you’re doing what you should to protect your portfolio, just in case 2017 is less kind.
2016 has been good for stocks
The S&P 500 is up 13 percent this year; the MSCI All Country World Index is up 9 percent; the MSCI Asia ex Japan Index is up 4 percent. Even troubled Europe’s markets had a positive year, up 4 percent.
In fact, one of the only major markets that had a negative year is China – the Shanghai Composite is down 9 percent on the year.
After a relatively good run, it’s easy to think that next year will be more of the same. But this status quo bias is the enemy of portfolio performance. Investing is like driving: It’s best to be defensive. So here are five (and one) steps you should take to ensure that you’re not caught off guard in 2017.
1. Keep some cash on hand
You’d be smart to have more cash in your portfolio. Yes, it doesn’t pay much, its value erodes over time (thanks to long-term inflation), and if you lose it (or put it through the washing machine), it’s gone forever.
But, over the short term – like the next year or so – the value of your cash stays constant (unless you live in Venezuela or Zimbabwe). And the value of your cash won’t change if markets crash.
Holding cash is one of the easiest ways to hedge your portfolio. Hedging helps reduce investment losses when your investment strategy doesn’t work out as planned.
Here’s an example of how it works… Let’s say you have $50,000 in stocks and an equal sum in cash, for a total portfolio value of $100,000.
Then let’s say the stocks drop 5 percent, but the cash’s value stays the same. This means that you have a paper loss of $2,500 on a $100,000 portfolio – down 2.5 percent.
But if the entire portfolio was in stocks, the loss would be $5,000, or 5 percent. So, cash was the perfect hedge, cutting your losses in half.
Plus, having some cash on hand let’s you take advantage of any great investment opportunities that may come up. It lets you pick up “money lying in the corner.”
So take some profits off the table to free up some cash.
2. Stick to your stop-loss levels
No one likes to admit defeat. But in investing, it’s important to have a disciplined approach to selling your bad positions and losing the battle. Otherwise, you risk losing the war when a few bad stocks wipe you out altogether.
Every investor has bought a share that’s gone down – an idea that seemed good at the time but is now down 10 percent, 30 percent, 50 percent or more. You might tell yourself a loss isn’t a loss until you sell. And (you tell yourself), if you sell now, you’ll miss the rebound that will make up for everything.
But the key to not losing money isn’t to wait for the rebound – because it often doesn’t come, ever. The key to not losing money is to sell before you feel the need to wait for a rebound.
The best way to do this is to use a trailing stop.
Here’s an example of how it works: if you bought a stock at $2.00, you might set your trailing stop at 20 percent below that level, or $1.60. In this case, as long as you stick to your trailing stop, you’ll protect yourself against far greater losses.
On the other hand, let’s say that same stock climbs $2.20. As the shares rose, you would continually adjust your trailing loss level to 20 percent below the market price. At $2.20, your sell level would be $1.76. If the shares rose to $3.00, your trailing stop would stand at $2.40.
The important thing is to follow through. If the stock falls to the stop loss level price, sell… no questions asked. And make sure you don’t put a standing market order in at your trailing stop level. You don’t want to tell your broker when you’re going to sell. Make sure that you make it a mental level – not one that you tell your broker.
This involves diversification by asset class (like stocks and bonds), and then by sector and company. You can also diversify across markets and economies.
Then look at assets, industries and countries that have a low or negative correlation – ones that won’t all move in the same direction at the same time.
A look at the historical correlations between different markets and asset classes (like stocks and bonds) shows that, over the long term, this generally works. (Remember, a lower number means the two assets have a lower correlation.)
For example, as shown in the table below, over the past 28 years, bonds and the S&P 500 have a correlation of only 0.29. Developed markets (the MSCI EAFE Index) and the MSCI Emerging Markets Index have a correlation of 0.7.
But when there’s a crisis, the usual correlation trends go out the window. Correlations between all markets and asset classes rise sharply, as shown for correlations during the global economic crisis (which we calculate here as November 2007-February 2009).
For example, during the global economic crisis the correlation between bonds and the S&P 500 rose to 0.53. The correlation between developed markets and the MSCI Emerging Markets Index increased to a near-perfect 0.94.
Being properly diversified is like playing defense with your portfolio. And when markets are hitting all-time highs, like they have been in the U.S., it’s time to move from offense to defense.
4. Show your portfolio the world
Investing locally means investing in what you know – which, as we’ve written before, is generally smart. But some investors take it too far and invest way too much money in their home market.
One study showed that the average American with a stock portfolio has 79 percent of her money in U.S.-listed stocks – while U.S. stocks accounted for just slightly over half of the world’s total market capitalisation. Investors in Japan put about 55 percent of their money in Japan-listed stocks, although Japanese shares were just 7 percent of the total. And people in Australia have two-thirds of their portfolio in local stocks, which accounted for only 2 percent of the world’s shares.
And even though Singapore’s stock market is only 0.4 percent of the world total, Singaporeans invest about 39 percent in domestic equities.
What this means is that most investors are hugely over-exposed to their home market. Not only do they live there, work there, use the local currency, and have real estate holdings there – but they also buy shares there.
However, it makes a lot of sense to invest in other countries. And not just because of diversification, either. The correlations (explained above) between different countries’ markets have been climbing over the past decade.
From 1990-1995, for example, the correlation between the S&P 500 and Singapore’s STI was just 0.1, or almost no correlation at all. Over the past five years, the correlation has climbed to 0.3. Blame globalisation for this “correlation creep.”
The better reason to diversify globally is to help boost your returns. For example, and as shown in an earlier chart, Singapore’s STI is up 4 percent and Hong Kong’s Hang Seng is up 3 percent so far this year. But the S&P 500 is up 13 percent, Thailand’s market is up 16 percent and the MSCI All World Index is up 9 percent.
Including these other markets in your portfolio would have helped your portfolio’s returns in 2016, if you are a Singapore or Hong Kong investor.
5. Own gold
Gold moves independently of other asset classes, like stocks or bonds. It’s one of the best hedges against market volatility.
For instance, earlier this year, markets reeled due to worries over China’s economy and the devaluation of the renminbi. Many markets around the world entered bear market territory – meaning they were down 20 percent from their recent peaks. Hong Kong’s Hang Seng index lost 11 percent that month. And the MSCI World Index was down 6 percent.
But gold gained 5 percent in January… on its way to its best quarterly performance since 1986.
And even though gold prices have fallen from this year’s earlier highs, there are still other compelling reasons to own gold. These range from central banks’ zero-to-negative interest rate policies to global market uncertainty. We outline the entire case for gold in a special report you can download here, for free.
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