Are you prepared to make an exit from the stock market?

If the Federal Reserve pursues an “exit” from its ultra-low interest rate policy, are you be prepared for an exit from the stock market, should things turn south?

There’s a group of investors that say an “exit” is ludicrous – there’s no way the Fed will pull off an exit. It turns out we sympathize with that view, but think getting ready for a Fed exit is still paramount. This is because just the hint of a Fed exit might cause havoc in the market, even if it is never actually pursued.

What not to do is a lot easier to say than what to do. Here are five common mistakes investors make:

• Feeling like you’re losing out because you’re not keeping up with the stock market. No: you should develop a financial plan tailored towards your circumstances. You should not care how much the guy or gal next to you, or the “market” makes.
• Feeling like you haven’t saved enough for retirement and as a result should invest in the stock market to make up the shortfall. No: Warren Buffett got to the point when he said: “The stock market has a very efficient way of transferring wealth from the impatient to the patient.” The prudent investor waits to find good values; the impatient investor is bound to invest at the top by chasing trends.
• Feeling like you can’t invest more because you don’t make enough money. For most, spending, not income is the problem. Remember the days back in college when you could live off very little? Spending $80 a month on a phone bill is a luxury, not a necessity.
• Not spending any time researching investment options. Many spend more time researching which HDTV to buy than researching an investment. Just because you can buy the world with a push of a button, doesn’t mean you should. You worked hard to earn those savings; now spend a little time researching what to do with your savings.
• Not understanding true diversification. Diversification is not about labels, but correlation. When policy makers are very engaged in the markets, asset prices may no longer reflect fundamentals, but instead reflect the next perceived intervention by policy makers. In practice, this has meant that many investments have been highly correlated in recent years. Differently said: if everything has gone up in your portfolio of late, you have a problem.

To navigate what’s ahead, note the following:

• Don’t be afraid of holding part of your portfolio in cash; it might be protecting you from potential losses elsewhere and give you “dry powder” to utilize as opportunities arise.
• If you are looking for diversification in today’s environment, consider alternative investments. At a recent conference on alternative investments, a large wealth manager argued – and I would agree – that 20% of alternative investments in a portfolio are advisable if one wants it to have a real impact on performance. If I look at the portfolio allocation of Harvard’s Management Company in 2013, they only had a U.S. equity allocation of 11%, but when it comes to alternatives, aside from a 16% allocation to private equity, they held a 15% allocation to absolute return; a 2% allocation to commodities; a 13% allocation to natural resources; importantly, they did not feel the need to chase yield, with a high yield allocation of only 2%. This isn’t investment advice and we are not suggesting everyone should replicate Harvard’s allocation, but this should give food for thought.
• Stocks might crash. Having just mentioned an asset allocation with an infinite investment horizon, it may be counter-intuitive to now caution about what may happen in the near to medium term. I can tell you that I’m personally concerned about a crash and am taking precautions. To the extent investors are exposed to stocks, I would encourage them to consider a strategy that employs some sort of hedging or protection; if, indeed, the markets continue to soar, this allows one to participate in some of the upward move. An alternative, of course, is to simply reduce the market exposure and leave the remainder un-hedged. If you were to ask me for my favorite investment idea today, it is to get ready for a severe correction in the market; as such, at the very least, I like to have cautioned investors.
• Bonds might be one of the worst investments over the next 10 years. But aren’t bonds supposed to rise due to so-called safe haven demand? They just might, and year-to-date bonds have done rather well. But the math doesn’t add up. If I look out 10 years, I don’t see how we can finance our deficits. Something has to change. I’ll leave it for others to find value in bonds. Personally, I don’t want to touch them with a 10-foot pole.
• The action may be in the currency markets. If I’m wrong on bonds it’s likely because central banks succeed in keeping rates low. But if they keep rates at artificially low levels, two things will happen: first, bonds won’t compensate investors for the risks they take. And second, there ought to be a valve, as the market can’t be fooled in the long-run. That valve may well be the currency markets. If bonds plunge central banks could step in to contain their decline, the currency may act as a valve. If you think this is only a problem for Japan, think again, as the U.S. is vulnerable to similar pressures. This is the key reason why we have made the currency markets our home turf, so that we may be able to stay a step ahead of policy makers as currency wars evolve.
• Gold as insurance? We may think the currency market is where the action is, but while investors have a (all too often misguided) view about the euro and the yen, it’s difficult to get investors excited about the Swedish krona. Frankly, we also like to keep it simple. And the simplest insurance against the mania of policy makers may well be gold. That doesn’t mean gold will always go up; it doesn’t even mean gold will go up more than, say, silver. But gold is influenced by fewer dynamics than other commodities because of its comparatively low industrial use. The fact that it’s ‘just a brick’ is a feature rather than a bug: because it’s not the gold that’s changing, it’s the value of the dollar or currencies.

Axel Merk is president and CIO of Merk Investments.