When preparing for a bad event, you likely need to be prepared for two distinct events. First, that the horrible thing happens. Second, that the horrible thing does not happen.
If you knew with certainty that your house was going to burn down, you would move before it happens. However, if you move out of your house and it does not burn down, you may have impoverished yourself and your life.
That is why possible home disasters are mitigated through risk reduction, risk transfer, and risk acceptance. You reduce your risk of a disastrous home fire through safety measures like owning a fire extinguisher. You transfer the risk to someone else through the purchase of insurance. And you accept some of the risk as possible and design your life so that if it happens you can go on.
Currently, the possible Taiwan conflict has the possibility of becoming World War 3. It is hard to tell what World War 3 would do to investment returns. Luckily though, there are several strategies already in place for limiting the effects of political risk.
What is more, these strategies are strong in both good times and bad.
At any given point, it is easy to come up with reasons not to invest. However, history says that you should not listen to those fears.
In The Market Realist’s article “Debunking Myths About the Stock Market and War as Russia Invades Ukraine,” author Mohit Oberoi explains how historically, war has created more volatility but actually had a positive effect on stock market returns.
- “U.S. stocks saw some wild swings during World War II. However, from the beginning of the war in 1939 to its eventual end in 1945, the Dow Jones gained almost 50 percent.”
- “U.S. stock markets increased by 43 percent between 1965 and 1973, which was the period when U.S. troops were in Vietnam.”
- “While it might sound counterintuitive, analysis by Mark Armbruster, CFA shows that stocks are less volatile during times of war. “
- “During the Iraq war, U.S. stock markets soared to record highs.”
- “Analysis by LPL Research shows that unless war is accompanied by a recession, stocks tend to take wars in their stride.”
While war is a human tragedy, it is not necessarily bad for business.
History tells us the markets trend upward like an escalator. This analogy sometimes makes people wonder, “The markets can’t go up forever, can they?” However, the answer to that question is, “They have so far.”
Stay invested now. Stay invested even if the markets go down. History says that wartime volatility will leave you better off than before.
Sometimes, you don’t get a second chance to be brave.
Diversification is a staple of financial advice. Don’t put all your eggs in one basket because if you drop the basket you won’t have any eggs. In the same way, don’t put all your assets in one company stock, one industry, or one country. If that area doesn’t perform well, you might have jeopardized your financial needs.
Diversification is responsible. It is the difference between being willing to break every bone in your body as an Olympic skier and safely skiing with friends. As David Marotta writes:
Even if you have the risk profile of an Olympic skier that doesn’t mean you need to have a do or die investment portfolio. When it comes to money, every investor should avoid the three cardinal investment sins: fear, greed, and pride. Fear keeps you off the slopes, greed makes you ski faster than is safe, and pride makes you risk everything in order to get a place on the podium.
In month-to-month snapshots, diversification dampens both the highs and the lows. You always have an investment to complain about and an investment that is your darling. But the goal isn’t to invest only in what goes up. The goal is to support your financial needs, which is why your portfolio needs diversification.
Diversification reduces unsystematic risk. Systematic risk is risk which is inherent in the market while unsystematic risk is risk which is specific to a handful of investments. Political risk — such as a possible war — is unsystematic risk. By also owning stocks which are not subject to that risk, you increase your diversification and can reduce that risk.
Some investments that are less likely to be affected by war are Consumer Staples, Health Care, and Utilities. These so-called Defensive stocks tend to maintain earnings and revenues even during market downturns. The idea is that, even with a war going on, people still need food, healthcare, and utilities.
Design efficient portfolios.
Risk and return are the two main performance metrics of a portfolio. Return is how much your investment gained in value over the time period, which is the reason you invested in the first place. Risk is how bumpy the journey was on your road to those gains.
Many investors think that the goal is to put everything in what you expect to go up the most. However, this strategy ignores the rebalancing bonus which is available to non-correlated assets.
Efficient portfolios are the portfolios which have the highest return given their level of risk. Oftentimes, the most efficient portfolios are created when you blend investments which have a low correlation to one another, as we have done in our U.S. Stock strategy.
An efficient portfolio with low correlation can weather market downturns of any type. Diversified components in your portfolio will cause distinct behaviors for each individual allocation. A portfolio where components alternate who is the dog and who is the darling creates an overall smoother ride.
Make half a mistake.
“Make half a mistake” is a strategy for making a decision in the face of an uncertain future.
World War 3 may pose specific risks on your current portfolio about which you are concerned. Divesting from those sectors may impoverish your portfolio if your fears are not actualized. Keeping those sectors may impoverish your portfolio if your fears come true.
Rather than only picking one outcome, make half a mistake. If you are inclined to cut the position by 100%, cut it by 50%. If you are inclined to cut it by 50%, cut it by 25%.
In half a mistake, the glass is always partially full and partially empty. You know that it will be from the start.
Hindsight will always have better options. We made half a mistake when we cut some of our Hong Kong allocation. Hindsight would have said we could have cut it all. However, when faced with an uncertain future, hedging your bets is a good strategy. By doing only half of what you think is right, you protect yourself from being 100% wrong.
Make half a mistake and then celebrate that you weren’t entirely wrong.
Photo by Hasan Almasi on Unsplash. Image has been cropped.