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SMART INSIGHTS FROM PROFESSIONAL ADVISERS

How to Protect Your Portfolio Against Black Swans

Unpredictable macro events can roil financial markets. You need the right mindset for dealing with such big shocks.

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After the tremendous stock market boom of the 1980s and 1990s, investors thought they could do no wrong. But the events on September 11, 2001, shook everyone from their complacency. Investors realized that big forces outside of the market present a much greater risk than the inherent dynamics of the market.

See Also: How to Invest for the Coming Bear Market

Let's call these "macro events," and ever since 9/11, or so it seems, the markets have developed a sort of hypersensitivity to such shocks to the global economy, which has led to dramatic yo-yo movements in the markets. The challenge for investors is that the uncertainty of macro events isn't measurable in terms of their potential risk, which makes them all the more unsettling.

What exactly are macro events?

Natural disasters (Hurricane Katrina), geopolitical shocks (Arab Spring), systemic failures of markets and national economies (the European debt crisis or the Chinese currency devaluations of 2015) are all macro events that can occur with or without warning, but in most cases with far reaching, often global ramifications.

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The less-expected such events are, the more improbable, the more dangerous and damaging they can be. Called "black swan" events, in reference to the rarity of black-colored swans, they are generally not factored into investment models or asset allocation strategies or in the mindset of investors, so when they do occur, their impact on the markets can be devastating.

Whereas in the past, we might have experienced a black swan maybe once every few decades, they seem to be occurring with more frequency. Some of the events that have occurred in just the last decade, such as the 2008-2009 financial meltdown and the Japanese earthquake-tsunami, would be considered black swans. And this high rate of rare-bird spotting has had a paralyzing effect on investors fearful over the uncertainty of the next occurrence.

What You Can Do

Preparing your portfolio for the uncertainty of macro events is not as difficult as you might think. However, investors who have strayed from the basic fundamentals of long-term investing may find it challenging.

First and foremost, you need the proper mindset. You have to be able to keep your perspective in place and your fears in check.

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Consider the most successful investor of all time, Warren Buffet, who has made billions by preying on investors' fears, buying while everyone else was selling. In his 1994 Berkshire Hathaway shareholder letter, he wrote:

"Imagine the cost to us, then, if we had let a fear of unknowns cause us to defer or alter the deployment of capital. Indeed, we have usually made our best purchases when apprehensions about some macro event were at a peak. Fear is the foe of the faddist, but the friend of the fundamentalist…

A different set of major shocks is sure to occur in the next 30 years. We will neither try to predict these nor to profit from them. If we can identify businesses similar to those we have purchased in the past, external surprises will have little effect on our long-term results."

Second, stop listening to everybody else. Between the gurus, the pundits, social media and the guys around the water cooler, it has become a deafening world, and all that noise has very little to do with your specifics goal and objectives. The movements of the markets are driven as much by herd mentality as they are fundamentals, and the two are very rarely in sync. Your gut is likely to be right more often than any market prognosticator. Or if you trust neither, you can adopt a dart-throwing monkey because it can't do any worse. Better yet, set a strategy based on your investment objectives, preferences, priorities and risk tolerance because they are the only benchmarks that matter.

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Third, diversify, diversify, diversify. Diversification in contemplation of macro events is a little more involved than simply spreading your money out among a lot of equities and bonds. It's important to structure your portfolio with varying types of asset classes that act as counterweights in responding to different economic or financial circumstances. For instance, a macroevent that sends the dollar plunging will likely drive up the price of gold. A spike in inflation could depress most small and mid-cap stocks but boost large, dividend-paying stocks. By creating more non-correlations among different asset classes, your overall portfolio will have more stability over time.

Fourth, do not try to time the market. It simply doesn't work. Most investors sell near market bottoms and buy near the tops. Investors who fled the market in 2008-2009 will never recover the 40% or 50% loss they incurred when they sold near the bottom. Instead, adjust your exposure based on what you perceive as happening. Stay with your allocation strategy and use market declines as opportunities to buy while using market rallies as opportunities to capture some gains, but always try to keep your allocation the same.

Finally, invest for your own purposes, and keep your eye on your target. That is the only benchmark that really matters. You don't need to chase market returns (the latest hot stock or mutual fund). If your portfolio is averaging the 7% or 8% return you need to achieve your long-term investment objectives, what does it matter if XYZ fund gained 27% this year? There is a good chance that fund will underperform the market next year.

See Also: Prepare Your Retirement Portfolio for a Downturn

Woodring is founding partner of San Francisco Bay area Cypress Partners, a fee-only wealth consulting practice that provides personalized, comprehensive services that help retirees and busy professionals to enjoy life free of financial concern.

Craig Slayen, a new partner with Cypress Partners, contributed to this article.

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This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff.