How to protect your portfolio from volatility

By Kim Iskyan

If there's one thing investors hate, it's volatility.

After seeing global markets head higher and higher for the past decade, it's hard to see markets fall by 5, 10, or 15 percent (like we did in February).

But corrections are normal.

And the fact is, sooner or later the good times have to end.

Mean reversion means that markets (along with pretty much anything else in life) tend over time to reverse extreme movements - and gravitate back to average.

It's like a rubber band… stretch it and when you let go it returns to its original shape. So after a period of rising prices, securities tend to deliver average or poor returns. Likewise, market prices that decline too far, too fast, tend to rebound. That's mean reversion, and it works over short and long periods.

And right now, markets around the world are "stretched" and could snap back to their "original shape" at any moment.

That means now is the time to prepare for whatever might happen… whether it's another market correction, a crisis, a currency collapse, or something far worse.

So here are five things you can go right now to prepare for future market volatility…

1. Get your portfolio out of the house

For many people, there's no place like home. It's familiar and comfortable. But keeping your portfolio in your home country can be risky.

The idea behind diversification is simple. It means putting your eggs in different baskets. That is, spreading your risk across different types of assets, so that a decline in value in any one holding isn't so bad - because there will likely be other holdings that rise to help balance out the losses. And geographical diversification is important.

Spreading a portfolio around the world reduces risk. After all, gains in one market can offset losses in another.

And while the gains in some markets are nearing an end, they're just getting started in markets like India, Bangladesh and Vietnam. These are three of the fastest-growing markets in the world.

So do yourself a favour and diversify your portfolio.

2. Invest in alternative assets

It's important to diversify your portfolio - not just outside your home country or in different types of companies - but through different assets. One way to do that is by owning commodities.

You see, many commodities are negatively correlated to stock markets.

Correlation is the relationship between two or more assets. When assets are negatively correlated, their prices tend to move in opposite directions. When they're positively correlated, their prices tend to move in the same direction.

Take gold, for example.

History has proven time and again that gold is one of the best ways to hedge your portfolio - that is, to protect it when stock markets everywhere fall. That's because gold and stock markets are negatively correlated assets. That means when equity markets go down, gold usually goes up - and when gold goes down, equity markets tend to go higher.

That's why gold has outperformed through countless crises and "black swan" events throughout history.

3. Follow your stop-loss levels

If you own shares, you need to have in mind a stop-loss for every stock you own. Just as important, if a stock you hold hits your stop-loss level (the lowest price at which you're willing to sell to limit your losses if a stock falls), sell. You can't make money by investing if you don't have money to invest.

A stock that's down 50 percent has to double before you get back to breakeven. How often have you invested in a stock that's doubled? Probably not often enough to count on it. It's much better to have a stop loss level that's (say) 25 percent below where you bought the stock (and raise the actual stop-loss level as the share price rises) than to be out of the game.

4. Hold cash

Everyone would be smart to have more cash in their portfolio. Yes, it doesn't pay much, its value erodes over time (due to inflation), and if you lose it (or put it through the washing machine), it's gone forever.

But, over the short term - like the next year or so - the value of your cash stays constant (unless you live in Venezuela or Zimbabwe). And the value of your cash won't change if markets crash.

Holding cash is one of the easiest ways to hedge your portfolio. Hedging helps reduce investment losses when your investment strategy doesn't work out as planned.

Plus, having some cash on hand lets you take advantage of any great investment opportunities that may come up. It lets you pick up "money lying in the corner."

So protect your portfolio by taking some profits off the table to raise some cash.

5. Don't think your VIX ETF will rescue you

The VIX - sometimes called the "fear index" - measures demand for options in S&P 500 stocks used by big investors to insure their stock portfolios against loss. A high VIX reading indicates investors expect high volatility in coming weeks, and their demand for insurance is driving option prices higher.

But unlike the S&P 500 or other indices, there's no way to invest directly in the VIX index. Of course, that hasn't stopped financial engineers from creating derivative products that try (mostly unsuccessfully) to track the VIX.

VIX futures and options on futures have been around for years. However, futures in general are risky - and futures on volatility even more so. These instruments are only for experienced traders who can afford to lose their entire investment very quickly.

It's easy to suggest buying a VIX ETF to protect your portfolio in case volatility picks up. A crashing market=higher volatility=great portfolio insurance from a VIX ETF, right?

But ETF-like VIX products have some of the worst performance in history. Unless you choose exactly the right moment, you're assured to either blow yourself up quickly… or slowly.

In short, if you're buying VIX ETFs, you might as well go gamble.

To sum up, following these five tips will help you prepare for whatever is coming next for the markets.

 

Kim Iskyan
Kim Iskyan is the publisher of Stansberry Churchouse Research, an independent investment research company based in Singapore and Hong Kong that delivers investment insight on Asia and around the world. Kim has nearly 25 years of experience as a stock analyst, hedge fund manager, political risk consultant, and financial commentator in more than half a dozen emerging and frontier markets. He's been quoted in the Economist, The New York Times, the Wall Street Journal, Barron's, and Bloomberg, and has appeared on Fox Business News, China Central Television, and Bloomberg TV, and has written commentary for the Wall Street Journal, Slate.com, Salon, TheStreet.com, breakingviews.com, and other publications. For more of his insights, Click here to sign up to receive the Asia Wealth Investment Daily in your inbox every day, for free.

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