"My crystal ball is in the shop." That's how I usually answer the impossible question of where things are headed in the markets over the coming days, weeks, and years. And I've been getting that question a lot recently as change seems to be the new normal.
On an almost daily basis, we're hit with a barrage of new information and geopolitical shifts that will have an effect on our investments. We're then left to wonder what the ramifications are of China's slowing economy, or what the fallout will be from Spain's debt crisis or what will happen next with the political situation in Iran.
For those of us in the investment world, all of this uncertainty can keep us up at night - especially because we can't accurately predict what will happen in the aftermath of all this change. My point is that, even if we knew what would happen in the world, could we profit from it?
Unexpected Outcomes
Consider what happened after Japan was struck by a devastating earthquake and tsunami. Not only was the nation forced to deal with the fallout from damaged nuclear plants, it's export-driven economy nearly ground to a halt. From a predictive standpoint, you might have guessed that these horrific events would have sent the Yen, Japan's currency, tumbling. But that's not what happened. The Yen soared so much, that the G7 nations had to intervene -one of the first times they have done so since WWII - to keep it from going higher.
Another example of economic unpredictability came when Standard & Poor's downgraded the U.S. government's credit rating. President Obama himself predicted that if the credit rating dropped, it would become more expensive for the government to borrow money, which would only further exacerbate the country's debt problems. However, after the S&P's action, investor demand in U.S. Treasuries spiked and interest rates actually plummeted.
As a third example, let's go back to the tragic events of September 11, 2001. Given what happened that day and all the uncertainty it created around the world, it would have been reasonable to assume that prices for commodities like oil and gold would have soared in the days that followed. But the price of a barrel of oil went up just $1 before it plummeted by some 25% over the next six months. Similarly, the price of gold rose modestly before settling in at about the same pre-9/11 price at year's end.
Of course, after the fact, we know why these things happened. In the wake of the credit downgrade, for instance, investors bought U.S. Treasuries because they're still considered the safest investment around. Oil prices dropped after 9/11 because people stopped traveling, which decreased demand.
Again, the point is that as investors, it's become increasingly hard to predict how markets will react to major events around the world because, oftentimes, the opposite of conventional wisdom occurs.
Investing Without a Crystal Ball
That's why as I manage my client's money, it's become essential to stress test our portfolios against such unpredictability, and to then hedge our bets. There are several ways to do this, and I recommend doing at least the following 6 things:
1. Don't just make the leap that certain assets will soar (i.e. gold, oil) if there is trouble around the world. Much like the earlier examples, counterintuitive reactions can and do happen, leading many investors to make the wrong move. When stress-testing your portfolio, it's important to consider the actual financial impact of an event (stronger dollar/weaker dollar) rather than the geopolitical event itself (like war in the Middle East).
2. Just in case half the world is correct and we see higher interest rates, make a list of what assets are likely to be sensitive and consider how they will react. In general, the best performing bonds over the past year are those that have benefitted from falling rates. These may underperform if rates rise.
3. Evaluate the underlying sectors and holdings within funds you own. Many of the best performing funds in the first two years of this recovery did so with foresight to own commodities and materials stocks. Combining these with other holdings in the direct commodity space - stocks or sector funds - left many overexposed in 2011.
4. Use the transitive property you learned in high school. If assets are all tied to one factor (like the economy, price of the dollar, etc), then they are tied to each other. So if both emerging market stocks and your global bond fund benefit from a weakening dollar, they may get hit if we see a strengthening dollar like we saw during periods last year. (Yes, Mr. Pierce, I just used the transitive property as a grown-up)
5. Consider investments whose performance is not so closely tied with global / macro issues or interest rates. One investment we have used for years is a strategy called merger arbitrage. In essence, these look to make a small profit on announced and pending mergers. This is probably the simplest of the alternative strategies, and there are several no-load ETFs and funds that employ this strategy.
6. Invest with managers who pride themselves on investing in companies without global exposure. Our small cap strategy avoids companies that cannot finance their own debt, or have any sort of government interference. This traditionally keeps us out of banks and media companies. We believe that most of these companies would continue to do business even if credit once again dries up.
In these cases, we are not trying to predict (or debate) what may happen globally, or even what may result financially. We are being prudent to test our diversification strategies to be sure we are not overexposed.
When it comes down to it, my role as a financial planner and investment manager is to prepare for the best - and the worst - of anything. The world is just too unpredictable to do anything less.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.