You're in a darkened room — a shelter of some kind. Outside, you see mobs with torches; you hear air raid sirens. You turn on the television as an ashen-faced Jim Cramer is shouting "Sell! Sell! Sell!"
The screen goes blank.
Who hasn't had a dream like that? If you're a financial adviser, your anxiety about the markets and the world in general have probably been rising. Both the U.S. stock and bond markets are historically expensive; parts of Texas are enduring horrific flooding; North Korea continues to launch missiles; and terrorist attacks flare up with depressing regularity around the world.
The question: How do you adequately protect a portfolio against the worst an increasingly risky world could offer? The traditional hedges against stock market downturns are bonds, cash and gold. The correct answer: All of the above.
But before you give a thought to the tools you need for hedging, you should also give some thought to the kind of risks you're hedging against. Unless you've severely misjudged your attitudes towards risk — or neglected to find out when your clients will need to spend their money — then your best hedge is time, particularly for stocks. Corporate earnings will snap back far more quickly than reinvested interest or gold prices.
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Research Affiliates notes that volatility is highest over one-year periods, and lowest over 10-year periods. That observation holds true not just for U.S. stocks, but for 15 different asset classes, including international stocks, high-yield bonds and commodities. "Whereas our fast-paced, performance-obsessed world taunts us to assess our portfolios over very short horizons, most investors actually have a sufficiently long horizon to enjoy the benefits of time diversification," authors Amie Ko and Michael Aked write.
And trying to hedge against short-term risks is a mug's game. "The reality is, your timing is going to be off," said Steve Janachowski, CEO of Brouwer & Janachowski. "In the meantime, you're paying a huge price and you may never be right. It does more damage than good to take short-term tactical measures."
Assuming a long-term outlook, then, your next question should be, "What risks am I trying to hedge against to protect my portfolio and my family?" William Bernstein, author of The Four Pillars of Investing and co-author of Efficient Frontier Advisors, said that advisers should be mindful of "deep risk" events – those that could cause a permanent loss of capital. Those include severe, prolonged hyperinflation or deflation, governmental confiscation of assets, and geopolitical disaster.
"If you look at retirement calculators, such as those that use Monte Carlo simulations, you can find portfolios with a 1% chance of failure, which implies more or less one failure every 4,000 years," Mr. Bernstein said. "But human history is not that kind: You can expect failure at least once every 500 years."
Obviously, some catastrophes are more likely than others. The odds of a conventional war or civil war on U.S. soil remains (relatively) small, which is fortunate, because the only real hedge against that is to hold assets in a safer country. And even in the case of war, domestic equities tend to be a better bet than bonds: Your return on Japanese and German equities after World War II were better than the return on German or Japanese bonds.
If you're worried about disaster, such as the people of Houston are undergoing, then it makes sense to have some cash available. If the streets are flooded and the ATMs aren't working, Mr. Janachowski said, you'll want some cash for food and water — as well as for hiring people to get that tree off your veranda.
Gold, too, has its place in your portfolio to safeguard against disaster, although things will have to be awfully bad for you to buy groceries with it. Gold is a better hedge against economic calamity than inflation. The yellow metal has a spotty correlation, at best, with inflation. For example, gold fell 50% from 1980 through July 1999, while inflation rose 117%. And gold soared from $255 an ounce in July 1999 to $1,895 an ounce in 2011, when inflation was relatively benign.
Nevertheless, gold did fare well during the economic crisis of 2008, when deflation, and economic collapse were the biggest worries. "If you get a real civil disturbance, gold could double in price," Mr. Bernstein said.
Precious metals stocks would fare even better when there's geopolitical instability or if there's widespread banking failures, which didn't occur in 2008 because of deposit insurance. "They could dull a lot of the pain," Mr. Bernstein said. A convenient way to hold gold bullion is through commodity gold funds, such as SPDR Gold Shares (GLD). For gold mining stocks, iShares Global Gold Miners (RING) is a reasonable choice.
Treasury bonds are a good hedge against worldwide unrest as well, Mr. Janachowski said. "If things go bad, everyone flock to Treasuries," he said. Corporate bonds sold off during the financial crisis, because of the risk of default. Treasuries held up because of their low credit risk – and the fact that their regular interest payments become progressively more valuable in a period of falling prices.
In today's monetary system, the most likely long-term danger to wealth is probably high inflation. Given the choice between cutting Social Security and Medicare benefits, raising taxes, and printing money, printing money is the most politically palatable solution, Mr. Bernstein said. "It's endemic in financial history." Here, too, the best hedges are probably stocks, although real estate might fare well if interest rates don't soar.
One solution is a fund that's designed for all circumstances, such as the Permanent Portfolio fund (PRPFX), which keeps money in stocks, gold, cash and Swiss francs. The fund has gained an average 7.76% a year the past 15 years. "There's nothing wrong with the Permanent Portfolio," Mr. Bernstein said. "If you stick with it, you'll never have spectacular returns, but you'll do tolerably well. Our job isn't to make clients rich, because they already are. Our job is to make sure they don't get poor."