By Jonathan Burton, MarketWatch
SAN FRANCISCO (MarketWatch) — Mother was wrong: What you don’t know can hurt you.
Investors nowadays should realize this all too well, as headline-making events are forcing people to expect the unexpected. Unrest in the Middle East and North Africa and disaster in Japan have added to known worries like faltering economic growth and the specter of rising inflation. And there are still eight months to go in 2011.
Back to 1987
Our Trading Deck has been home to a spirited debate over whether we're in for a crash.
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None of these events has been calamitous for the stock market. But there are signs that investors are anxious. Even the death of Osama bin Laden failed to lift stocks measurably, as investors considered possible repercussions from the killing of the al Qaeda leader and remained concerned about the health of global economic growth. Read more: Why the market isn’t reacting to bin Laden's death.
Accordingly, investors should take this chance to give their portfolio a stress test: Look at the risks it faces and strengthen any weak spots.
Bernard Baumohl, chief global economist at Economic Outlook Group in Princeton, N.J., advises reviewing each of your holdings, assessing their vulnerability to a potential shock and then making sure you’re not overexposed to any one country or sector. And consider liquidity, or how easily you can sell the asset if the need arises.
Too many individual investors, and even professionals, get into trouble by underestimating or ignoring what could go wrong.
“Embark on a strategy that will preserve capital in a period of heightened volatility,” said David Rosenberg, chief economist and strategist at Toronto-based wealth-management firm Gluskin Sheff. “It’s a matter of assessing risk, of identifying opportunities and basically looking at the forest past the trees. It’s not about market timing.”
Stress tests are no guarantee against losses — 2008 proves that — but a periodic portfolio review at least gives a baseline picture of whether your investments are diversified enough to handle Mr. Market’s wild ride. With that in mind, here’s a look at some of the biggest risks around, and what you can do to protect your portfolio from them.
1. Risks you know you need to think about: inflation, interest rates
While the U.S. inflation rate is far from the crushing double-digit levels of 35 years ago, higher energy and commodity costs are taking a toll on consumers and producers alike.
The question investors need to ask is how much of this sticker shock is due to speculation. When speculators grab hold of a market, prices can soar rapidly and sink just as quickly. Investors have to weigh that factor against supply-and-demand realities.
Coincident with inflation risk is interest-rate risk. Many market observers are convinced that rates have nowhere to go but up — and soon.
Rising rates reduce the value of existing bonds, especially longer-term issues, bringing pain to bond investors. The throngs who flocked to bond mutual funds over the past couple of years need only look at what happened to bond-fund share prices in 1994, when rates jumped. By the end of that year, the average taxable-bond fund had lost 3.3%, according to investment researcher Morningstar Inc. Already this year, shareholders of long-term government-bond funds and many municipal-bond funds are getting pinched.
Your best bet: Make sure your portfolio is broadly and efficiently diversified. Own U.S. and international stocks, commodities, inflation-protected bonds, real-estate investment trusts and cash, all of which have the ability to withstand inflationary bouts. Cash is king when interest rates rise, as money-market funds and bank certificates of deposit pay correspondingly more.
But don’t abandon traditional bonds. Diversification isn’t about maximizing return; it’s about minimizing risk. That means owning unpopular assets — because you could be wrong. High-quality U.S. and international corporate and government bonds of varying maturities, or bond funds that own these securities, provide you with diversification and lower the risk of a stock-heavy portfolio.
Many bond-market strategists nowadays advise controlling interest-rate risk by shortening a bond portfolio’s duration, or sensitivity to rate swings. Bonds that mature in five years or sooner, for example, don’t suffer as much as longer-term issues when rates climb, since once they mature their proceeds can be reinvested at prevailing higher yields. Bond funds don’t have maturity dates, but their investment objective is usually stated in the fund’s name, and the portfolio’s average duration is easily found online.
Finally, keep in mind that most assets nowadays are correlated, meaning they move in the same direction, though not to the same degree. In fact, the only global assets now that are truly uncorrelated with stocks, bonds, commodities and precious metals are Treasury bonds, according to Morningstar. If fears of sharply rising inflation and interest rates are unfounded, or when another geopolitical shock spurs investors to seek safety, Treasurys will be in good graces again.