Simon Moore* says depending on the nature of the economic crisis, different assets can offer more or less protection.
You may already be familiar with the typical portfolio construction guidance, buying less cyclical or non-correlated assets can help protect your money in a crisis.
That’s generally true.
Depending on the nature of the crisis different assets can offer more or less protection.
However, the key to the message is to buy before the crisis hits for the real protective benefit.
As it stands today, the level of market stress is elevated.
This means that certain potentially protective assets are becoming richly valued relative to history.
Though there are many defensible reasons to consider a stock-heavy portfolio as a long-term investor, that decision comes with the ups and downs of volatility.
As we have seen recently, stocks can suffer heavy losses when the perceived outlook for the economy darkens.
Nonetheless, a diversified portfolio of stocks is perhaps the best-performing major asset class over time on most measures.
Still, losing money, even temporarily, hurts.
Managing the risk of a stock portfolio can be prudent.
If you can’t stick with a portfolio, you’re less likely to see the anticipated benefit of being a long-term stock investor.
Ups and downs are an inevitable part of investing.
The problem is that it can be better to make that shift to risk protection for your portfolio during calmer markets.
Right now, the markets are in panic mode and many typically protective assets have their prices bid up; this means they may offer less protection than usual because their prices can fall back somewhat.
For example, if we take the US Treasury 10-year bond, yields are currently approaching 1 per cent, which is about as low a yield as we’ve seen in recent history.
Yes, yields could always fall further, and high-quality bonds may outperform stocks should the crisis deepen, but from here there’s a danger that bonds revert to higher yields even if things do get worse, creating a mild loss for investors from today’s prices.
That said, the volatility associated with bond price movements is often a lot smaller than that on stocks.
So, bonds will likely offer some protection relative to stocks, it’s just that today’s prices maybe a less than ideal entry point.
Put options, too, can be a way to protect your portfolio given that they generally rise in value as underlying assets fall.
However, again, valuations are now clearly elevated.
Put options are looking expensive in most scenarios unless the markets do drop a lot more.
Again, this could happen, but rushing into put options now may not create the outcome you expect.
This is because a key part of the value of a put option is the premium you’re paying for the privilege of the insurance.
Other sources of protection don’t suffer from this issue of getting prices bid up in times of market panic.
The most obvious candidate here is cash.
Cash is an asset necessarily less subject to price swings and can generally be a safe haven.
However, the problem with cash is a little different.
Cash typically offers little prospect of a return above inflation.
Therefore, cash will eat into your real returns over the longer term if history is any guide.
Hence moving into cash can be easy, but cash seldom wins for long, staying in cash can be costly and moving back into the market can be a tough call.
If you do move into cash, it can help to also consider what criteria you’ll use to move back into stocks or other assets at some point, so you don’t get stuck in a less efficient allocation for the longer term.
Also, in some crises, commodities, including gold and oil, can be a source of protection.
This is not because they always rise in a bear market, but because they march to the beat of a different drum in terms of their supply and demand drivers.
In this crisis so far commodities have fared less well, this is likely due to expected reduction in demand, especially since China is such a large consumer of most commodities.
However, given the nature of the crisis there is no guarantee that commodity exposure serves to protect your portfolio this time around.
So, making sure your portfolio is one you can live with through all market environments is always a good idea.
The challenge is that right now, some of the substitutes you might use to shift out of stocks may be a little elevated in price, certain bonds and put options are more obvious examples depending on how events play out from here.
Yes, if you believe things are getting a lot worse, these assets may make sense for you, and with bonds even if you time it wrong, volatility is a lot less than stocks.
However, if you’re merely looking to take some risk off the table without having a decidedly negative view on the economy’s prospects, moving into traditionally protective vehicles such as bonds and put options may not work out as planned if we’re at the height of crisis.
These assets have already priced in a fair degree of future bad outcomes and if that doesn’t play out, they may lose value.
The simple alternative of cash might work out better as being a more neutral asset in terms of risk pricing.
Adjusting your portfolio in the midst of a crisis creates its own complications.
At this point certain “risk off” assets have become less of a routine trade and more of a implied bet that things will get worse from here given how things are priced.
Further bad news is probable and equity valuations may still be expensive but think through the implications of any portfolio shift you are making and consider incremental adjustments for the long term rather than all-or-nothing trades based on short-term predictions.
* Simon Moore is a Senior Contributor to Forbes. He tweets at @simonwmoore.
This article first appeared at www.forbes.com.