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Thursday, August 02, 2007

Four safe and smart strategies—and one riskier play for the truly bearish—for investors who expect the worst

The 2007 Bunker Portfolio
Four safe and smart strategies—and one riskier play for the truly bearish—for investors who expect the worst
by Ben Steverman
Copyright by Business Week
August 2, 2007, 7:45PM EST

No one really knows where the stock market is going. Is the late-July plunge in stock indexes a momentary blip, or a sign of worse things to come? Will credit troubles and the ever-lower housing market do in the rest of the economy?

One thing is clear: Markets have entered a period of wild volatility. Indexes hit record highs and a week later fell almost 4% in two days.

"That is a sign the market is changing," says Hossein Kazemi, finance professor at the University of Massachusetts at Amherst. "There is a divergence of opinion" among investors, he says.

For this Five for the Money, we look at what investors can do to prepare for the worst. We call it our Bunker Portfolio. Feel free to compare this with last summer's edition, when the big worry was tension in the Middle East (see, 7/17/06, "The Bunker Portfolio").

Before we lay out a few strategies, though, some warnings courtesy of the financial advisors we consulted for this story:

Risk is part of investing. If you're investing for the long term, don't get spooked just because of a little bad news. You can miss out on a lot of upside if, as often happens, the worst fears aren't realized. Also, don't make any sudden moves you will regret. If you switch strategies too often, trading costs may eat up your returns.

If, however, you're going to need to cash in your investments soon—for retirement, tuitions, or a home purchase—it makes sense to keep your money in a safe place. As Austin (Tex.) planner Morgan Stone points out, a market crash just before you need the money would be disastrous.

Also, if you really believe stock prices have peaked and the economy is facing a world of hurt, a safer investment strategy just might help you sleep better at night.

Whatever happens, here are five ways to help your hard-earned cash survive downturns and disruptions. We start with the most conservative—some might say boring— strategies and move on to riskier ways to prosper if things get dire.

1. Cash

If you're really worried, "there is no shame in being in cash," Kazemi says. With cash you'll lose out on big returns, but you won't lose any of your principal.

If you do cash out of other investments, there are better places to put the money than burying it in the backyard. Money-market funds provide an entirely safe spot to park cash while still getting a decent return. Marshall Groom, a financial advisor based in Richmond, Va., recommends the Vanguard Prime Money Market (VMMXX) fund. Another risk-free option is bank certificates of deposit, which are insured (up to $100,000 at any one bank) by the federal government. CDs, however, lock up your money for a period of time, often at least six months.

Advisors recommend that you have at least some of your portfolio in cash at all times. Cash worth at least three or four months of expenses can help out mightily in an emergency.

Kazemi suggests the extremely cautious investor might wait on the sidelines in cash until October, when the ride might be a little less wild.

2. Bonds

The safest investment out there may be government bonds. Yes, prices can fall, but you're guaranteed a certain return if you hold the bonds until maturity. TIPS bonds are guaranteed to beat inflation, which can sap your portfolio's buying power. If things get bad, an interest rate cut by the Federal Reserve might boost bond prices.

Until recently, markets gave investors little incentive to invest in somewhat-riskier corporate bonds. Yields were barely higher than those on government debt. "The market basically ignored risk," says Micah Porter, president of the Minerva Planning Group in Atlanta. With the recent credit crunch, that's starting to change. Porter says it may make sense to buy corporate bonds, but he recommends only those with very high grades that will hold up if the economy worsens, defaults rise, or the credit crisis deepens.

3. International funds

Most advisors say international investments are part of any diversified portfolio. Much of the world's economic growth is expected to come from outside the U.S. For risk-averse investors, international exposure lets you avoid the impact of disruptions in the U.S.

Countless mutual funds and electronically traded funds (ETFs) let Americans invest cheaply abroad. International investing also helps protect against a declining U.S. dollar. But a few warnings are necessary:

Emerging markets such as India and China are booming, but they may be less stable than the U.S. There is less market research abroad, and regulations that protect investors aren't as strict, says Avani Ramnani of Athena Wealth Advisors in Jersey City, N.J.

Barbara Camaglia, of Ohio-based Legacy Financial Advisors, says it's important to distinguish between emerging markets and developed markets. Stocks in Europe are no more risky than U.S. stocks, she says.

One of the best ways to avoid risk is to diversify your portfolio to include assets that won't rise or fall in value together. Foreign investments used to move independently of those in the U.S., providing a good counterweight.

However, the extent to which investments correlate can change over time. Signs are increasing that world economies and stocks are becoming more and more connected as it gets easier to invest across borders. In late July, credit worries in the U.S. caused markets all around the world to fall at once. "Over time, they're going to run in tandem," says Brent Little, managing partner of Texas-based Odyssey Wealth Management.

4. Commodities

The booming global economy can't seem to get enough oil, metal, and other commodities. That could keep commodity prices high even if markets fall. Commodities also should hold value even if the dollar continues to fall or inflation heats up, Kazemi says.

Until recently, commodity investing for the small investor wasn't easy. But a variety of new ETFs offer investors inexpensive ways to get commodity exposure. Advisors recommend spreading your money across various commodities.

Commodities can be very volatile and "a little goes a long way," Minerva's Porter says. He recommends PIMCO's Commodity Real Return Strategy fund (PCRAX).

5. Alternative investments

Here's where things get riskier. If you have some money to play with and don't mind paying some hefty fees, you can find a fund manager with strategies for growing your money through even the worst economic turmoil.

Hedge funds were originally created just for this purpose: to be hedges against declines in other assets, like stocks. Thus, many private equity and hedge funds consciously try to move independently of equity markets, and often they succeed.

Investors, however, will need a high net worth to invest in hedge funds. It's risky, so you don't want to put all your eggs in one basket. "Diversification in the case of hedge funds is especially important," says Kazemi, who is a consultant to the not-for-profit Chartered Alternative Investment Analyst Assn. "You don't want to invest in a single manager."

Funds of funds give well-off investors a place to invest in a broad spectrum of hedge funds. However, they often add their own fees, on top of those of the hedge funds. "You are getting a second layer of fees, but you're also getting diversification that a small investor ordinarily couldn't get," Little says.

Some mutual funds specialize in providing returns in down markets. Kipley Lytel, managing partner of Montecito Capital Management, recommends the Hussman Strategic Growth fund (HSGFX).

Again, caution is needed here. This sort of investing requires a lot of skill and research. Many hedge fund strategies exist, some much more risky than others. And bearish mutual funds will provide mediocre results in a rising market.

The bottom line? Most financial advisors recommend against market timing, i.e., trying to bet exactly when the market has hit its peak. You'll probably be wrong.

A better strategy, they say, is to keep your portfolio diversified, spread among several asset classes from the safe to the risky. Then you'll be ready for almost anything.

"If you have a properly designed portfolio," according to Cathy Pareto of Florida-based Investor Solutions, "market corrections and economic disruptions become irrelevant."

Steverman is a reporter for BusinessWeek's Investing channel.


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