On November 17, 2019, a 55-year-old man in the Hubei province was tested positive for COVID-19, a disease caused by a novel coronavirus. His positive result started a series of events that led to lockdown in 50 countries and the biggest stock market crash of the 21st century. Nothing can prepare us for a pandemic, but we can adapt our portfolio and lifestyle to changing times. Below are the three things you can do to prepare yourself. On November 17, 2019, a 55-year-old man in the Hubei province was tested positive for COVID-19, a disease caused by a novel coronavirus. His positive result started a series of events that led to lockdown in a dozen countries and the biggest stock market crash of the decade. Nothing can prepare us for a pandemic, but we can adapt our portfolio and lifestyle to changing times. Below are the three things you can do to prepare yourself.
Embrace for impact
Investors usually overestimate their risk tolerance. In a falling market, I would recommend deleveraging your portfolio and investing only the capital that you can live without for the next ten years. Another good discipline is to review your holdings timely and identify weaknesses within your portfolio. Stocks you do not want in your portfolio are cyclical companies. Cyclical companies (i.e. Airlines, Hotels, Financial Services and Natural Resources) are the worst hit since the outbreak of COVID-19. Defensive stocks (i.e. Retail, Utilities and Healthcare) are more desirable during the current crisis as they provide essential goods and services for the economy to function properly. Ideally, you should create a watchlist of fundamentally strong defensive companies that you would like to buy.
A balanced All-Weather portfolio
Great portfolios are created by fine-tuning the balance between long term financial objectives and risk tolerance levels. One such great portfolio is the All-Weather Portfolio. All-Weather portfolio is the creation of Ray Dalio, the founder of Bridgewater Associates, one of the biggest hedge funds in the world. According to Mr Dalio, there are only four scenarios that can affect the value of your investments. They are as follows:1. Inflation – The increase in the price of goods and services or rising prices2. Deflation – The decrease in the price of goods and services or falling prices3. Rising economic growth – Flourishing economy or higher than expected economic growth4. Declining economic growth – Shrinking economy or lower than expected economic growth
Ray Dalio suggested constructing a portfolio with assets that would perform well in each of the above scenarios. The result is a diversified portfolio of Stocks, Bonds and Commodities. Performance of All-Weather portfolio in previous financial crashes:
- Great Depression – when back-tested during the Great Depression, the all-weather portfolio was shown to have lost just 20.55% while the S&P 500 lost 64.4%.
- In 1973 and 2002, when S&P suffered some of the worst losses, the all-weather portfolio made money.
Do not time the market but look for clues
I wish I had a magic bullet to protect your investments from market crashes. I don’t. But I want to help you protect your investments. COVID-19 has changed our perception of market volatility, but there are a few things we can look for to prepare ourselves.
Daily infection rate or growth factor of daily new cases: Growth factor is the factor by which the daily new cases number multiplies itself over time. A growth factor of 1.07 means the daily new case is growing by 7%. More than 1 indicates signs of increase, whereas less than one indicates decreasing levels. If the number stays below 1 for an extended period and continue to move towards 0, then there is a high likelihood that the market will improve. During the SARS crisis in 2003, the stock market bottomed a week after the daily infection rate topped out.
Fear Index: The current epidemic is anything like before, but there will be indications of revival. Stock market declines often coincide with VIX index spikes. Previous outbreaks of SARS in 2002-03 pushed VIX to 41. Global Financial Crash in 2008 spiked VIX to 79. As of March 24, 2020, VIX, is at 55. Before buying any stock, I would expect VIX to fall considerably. No one can predict when the market would bottom, but you can look for clues to give yourself a head start in building a better portfolio.
Key to better portfolio performance
The All-Weather Portfolio consists of 30% Stock, 40% Long Term Bonds, 15% Intermediate-Term Bonds, 7.5% Commodities and 7.5% Gold. The portfolio maximises diversification, minimises volatility and improves performance. Higher allocation of bond in the portfolio is to balance the volatility from Stock and Commodities as bonds are negatively correlated to stocks. Timing the market is fool’s errand. Buying when the valuations are right is key to better portfolio performance.