Is Your Portfolio Tough Enough?

This article published with permission from InvestmentU.com.

With the pressures of the holidays, a growing probability of going over the fiscal cliff and weak job security, a good New Year’s resolution for many might be to schedule a stress test.

For your portfolio, I mean.

Seriously, just how would your portfolio perform under the pressure of a market sell-off of 20% or spiking interest rates?

Diversification into conservative investments is always a good idea, but the “usual suspects” might not get the job done.

Municipal bonds? Fitch expects to downgrade dozens if not hundreds of issuers in 2013 as municipal finances worsen.

Japanese bonds? Japan’s largest bank’s CEO admitted this week that its holding of $485 billion of Japanese government bonds (JGB) were a “major risk” since they represent 900% of its base capital.

How about steady eddy dividend-paying blue-chip stocks? Even they got hammered just a few years ago during the financial crisis.

Remember, the unexpected can and will happen. The trick is not only preventing the unexpected from trampling your portfolio, but instead serving as a springboard for big gains.

Don’t hide from uncertainty, expect and embrace it, and it will make you stronger. This is the theme of Nassim Nicholas Taleb’s new 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 portfolios? First, don’t let big sell-offs ruin your nest egg and, then, be ready to turn a downturn to your advantage.

The Golden Rule — trailing stop loss

We’ve 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 — and should — handle. This sort of decline also 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%.

Hedging with inverse ETFs or ETF put options

Here are some ways you can “stay calm and carry on” by using some portfolio shock absorbers to cushion the blows when markets inevitably turn against you.

Many ETF investors are unaware that roughly 40% of ETFs have put options with maturities that go out as far at January 2015. Many hedge funds use a small amount of put options on the S&P 500 ETF (NYSE: SPY) to hedge their stock portfolios.

Before jumping into options trading, you should consult with your financial advisor and do some research as to 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 the markets, you should be aware that there are many inverse ETFs that move opposite the 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 the ProShares Short MSCI Emerging Markets (NYSE: EUM), which moves opposite the MSCI Emerging Market index. There are inverse ETFs out there on a wide range of assets from, oil to gold to U.S. Treasury bonds.

The point is not to go overboard with either of these strategies. But even a small allocation can cushion your portfolio from heavy losses.

Cash is king in a crisis

Many investors have a hard time holding meaningful amounts of cash in their portfolios.

Cash has to be put to work for a portfolio to grow, but if you’re 100% invested in your equity portfolio, how can you take advantage when the market hands you “fire sale” prices? Think of the gains if you had the cash and courage to invest in blue chips at the peak of the global financial crisis, or during the 1997 Asian crisis, or when emerging markets or bank stocks have been cheap as dirt.

Yes, taking some of these measures will be a drag on your portfolio returns in a major bull market, but I always say, better safe than sorry…

Carl Delfeld is a senior analyst at InvestmentU.com. See more articles by Carl here.