Welcome to The Giant Dipper — the large glowing sign flashes as it invites visitors at Santa Cruz Beach Boardwalk to give the historic wooden roller coaster a try. For those willing to cough up for the Park’s maximum five tickets, passenger will make their way onto a creaky, 1924 roller coaster nightmare. The ride begins by dropping riders into an inky black tunnel with disturbing twists, turns and drops. Screams reverberate in the darkness. The light at the end of the tunnel briefly consoles passengers until they realize they are being dragged up, hundreds of feet into the air, one clickety-clack at a time. As expected, a masterfully designed series of drops twists and turns follows filling the beach boardwalk with its ambient screams of fright as it has done for 88 years. Some things never change.
Welcome to a different giant dipper … that of investing in world markets. With Greece looking to exit, the resurrection of the drachma, Spain raising its hand for help, Italy un-liking austerity, Germany digging in, and risks of contagion, it is clear that the next big European recession is afoot. Be assured that the coming year will provide a ride to remember. Although no one knows how big this dip will be, prepared investors will survive the ride with their smile in tact. Here are two things to consider:
Secure your safety harness
Only a fool would board a roller coaster sans safety equipment, but surprisingly investors repeatedly lose sight of risk management within their portfolio. When making investment decisions, investors often overweight performance while underweighting risk. As stated by Stephen M. Horan, head of private wealth management at the CFA Institute, “Surprisingly, losses govern the accumulation of wealth to a dramatic extent.”
To manage risk, begin by focusing on two main portfolio concerns, asset allocation and fund diversification. Asset allocation, the act of strategically spreading your investments across a broad swath of global equities and bonds, has been commonly cited as accounting for about 90% of portfolio returns. This claim roils active money managers and significant effort has been put toward disproving this hypothesis. In 2000, Ibbotson and Kaplan performed an additional study which reaffirmed asset allocation as a major contributor to long-range returns.
To be sure, asset allocation is critical for managing risk. Make certain that your portfolio has a range of large- to small-capitalization U.S. equities, foreigner-developed stocks, emerging-market stocks, REITS, government and corporate bonds and even some commodity exposure. When it comes to securing a safe ride through economic recession, setting these weights properly is the most important investment decision you will make.
To further secure your safety harness, add fund diversification to your asset allocation. By buying low-cost index funds or quality ETFs, you are spreading your investment across hundreds if not thousands of companies with the purchase of one share of the index. With this diversification, you are free from the devastating effects of Enron- or BP-like disasters.
Stay on the track
Roller coasters are fine as long as the track is safe, well-engineered and well maintained. Many investors lack a clear and well-researched plan and thus lack a portfolio track to run upon. Others may have once developed a plan, but have forgotten to revisit the plan and re-up their commitment to the underlying philosophy and investment science. Such investors become easily rattled during big drops, and while horrified, are at risk of jumping the tracks causing an investment train wreck.
If you need help formulating a recession resistant strategy, take time to familiarize yourself with the writings of John Bogle, Burton Malkeil, William Bernstein and David Swenson, to name a few. Their ideas are rooted in science and will help you lay a solid portfolio foundation that can survive economic storms.
Recessions will come. Some investors will panic and jump the track. Others will scream and hold on tight, while experienced riders might just chuckle and get on with life. All who manage risk well, however, will exit with a smile. Indeed, some things never change.