How To Protect Your Investments In Down Markets (July 2008)

Written by Dominick Paoloni

I recently attended an investment seminar where the speaker talked about there being no safe place to hide in this global collapse, citing the fact that most major global indexes are down double digits since October 1, 2007. Listed below are the declines from October 1, 2007 through June 30,2008.

% Change
S&P 500
EAFE European
All European

Many experts think that the answer to this dilemma is to 1) sell everything to cash and wait for better times, or 2) hold on hoping the markets will come back.

In 2000, when the market started to fall, the average financial professional told their clients, “Hold on, the market will come back.” They continued to tell their clients this in 2000, 2001, and 2002. By the end of 2002, the average investor had watched their life savings deplete and sold at a bottom only to see the market climb for the next five years. On the other hand, the investors that held on through the down turn and waited out the bear market are just now breaking even on a CPI adjusted return basis. That is seven years of making no money.

If we can learn anything about the past, it is that both options those investors were given are the wrong choice. Why? The first choice is based on market timing, selling at a top and buying at a bottom. The great savants of the past like Granville and Gazarelli made profound correct predictions about the markets only to be 100% wrong in many future predictions. Even a broken clock is right twice a day. My mother always said “Beware of false prophets,” and never was a truer word spoken when it comes to market timers.

The second choice is based on marketing and not good factual science. Historically, if you bought the market in 1966, you would have lost 72% of your buying power by 1982 and it would have taken until 1998 to break even. So much for buy, hold and hope.

If you shouldn’t get off the bus and you shouldn’t stay on the bus, what should an investor do?

Simple, stay on the bus but wear a seat belt. If you were in a car accident without a seat belt and got badly hurt, would you stop driving? No, but I would bet that the next time you stepped into a car, you would be wearing a seat belt and maybe even a crash helmet.

So it goes that when investing in the global markets, you should have protection in your portfolio. It may slow you down a little, and you may not get the rush of 90-mph, 30% returns, but you have a much greater chance of reaching your desired destination. If the market crashes along the way you might get bruised, but not bloody and burned like those with no protection at all.

How do you build protection into your portfolio?

In order to understand how a “seat belt” works within your investment portfolio, you must first understand how assets move in relation to each other. The way in which two variables, or in this case assets, move together is called correlation. As the U.S. currency goes down in value, global currency goes up in value. This is an example of negative correlation. So, to have a seat belt against a falling US dollar, you should own foreign bonds. Currently, 53% of the IPS Conservative portfolio and 38% of the IPS Moderate portfolio are invested in assets that have historically gone up when the markets have gone down. This is how IPS has been able to achieve shallow losses in bear markets and consistent returns in bull markets.

*This article is not a recommendation to buy or sell and should not be considered investment advice. Please consult IPS or another financial advisor before making any investment decisions.