Prepare your portfolio for all events
Share analysis and advice by Nathan Bell
Share analysis and advice by Nathan BellI like to worry. It's what gets me up in the morning. So being asked to write a few hundred words on the top risks for the year is a real joy because, this year, there's plenty of material.Last year I was concerned with a potential Chinese slowdown, a high Australian dollar, inflationary (and deflationary) risk and a possible fall in house prices.This year I'm less worried about the immediate threat of inflation but, despite falls in house prices during the past 12 months, that risk hasn't receded.And the threat to Australia of a Chinese slowdown, while now more widely recognised, is even greater.So let's start there.ChinaAustralia's resilience in the GFC was due primarily to us having the resources China needed to buy.But you can't make a steady living from being in the right place at the right time all the time.Monumental investment imbalances remain in China and the command system allows them to continue to pile up. A sharp Chinese downturn would hurt Australia far more than anything else.No one can say if or when this might happen, although a senior associate at the Carnegie Endowment for International Peace and a finance professor at Peking University's Guanghua School of Management, Michael Pettis, thinks it could be at least another two or three years away.But trying to time the stall is a fool's game. Better to act early and forgo some upside than be wrong and dust serious amounts of capital.EuropeTurning to Europe, there's a real risk of the euro zone failing. A European banking crisis and severe recession would almost certainly ensue.Ordinarily, this might not be a problem for Australia but a European recession could be the trigger for a Chinese downturn.If the policy response to unemployment and stagnation is yet more austerity, that heightens the risk.The Western world is suffering from an absence of sufficient aggregate demand. Massive government spending cuts - as we've seen in Britain and as the US Republicans propose - would only make the problem worse.Either of these crises could trigger a fall in the Australian dollar, which is likely to self-correct at some stage anyway, which would then have a knock-on effect.Australian housing is, in my view, overpriced and the "pain" of the past year is merely the start of a process of moving back to fair value.Whether that occurs through a sharp correction or 10 years of flat house prices, I don't know.But bursting housing bubbles cause major economic pain, far more so than sharemarket downturns. Plenty to worry about, right?Prepare for all eventsI'm less concerned now than I was 12 months ago. None of these risks is new, which is why the All Ordinaries Index is almost 40 per cent less than its 2007 high.Much of the risk is clearly, as they say, priced in.Remember also that this isn't 2007. Big blue-chips now enjoy sound balance sheets and, in many cases, sport lower share prices.So the recent rally is an opportunity to prepare your portfolio for all events, including a bull market (yes, it's a possibility).Focus on best-of-breed companies and pay attention to the diversification of your portfolio. Ask yourself what would happen if residential property prices collapsed, or if China had a hard landing, and position your portfolio accordingly.Build your cash holdings to prepare for the opportunities that may well arise during the coming months but remember that interest rates may fall further and that inflation is ruinous over time. Cash is not a good long-term investment.Attractive stocks going cheapThe threat of a troubled housing market means you should limit your exposure to the big banks to no more than 10 per cent of your portfolio. And I'd avoid resources stocks such as Rio Tinto, Fortescue Metals and Newcrest Mining until their prices fall further. A China slowdown would produce rapid falls in commodity prices.The strong dollar means you should consider devoting a bigger proportion of your portfolio to international stocks, or Australian stocks with strong overseas earnings. Computershare, QBE Insurance and Macquarie Group are but three examples.But don't get carried away.Truly defensive stocks such as Woolworths, Metcash and Spark Infrastructure should serve you well in the event of a downturn.Attractive stocks are already cheap and we may get the chance to purchase them at even better prices during the next 12 months. Why worry about that?Nathan Bell is the research director at Intelligent Investor, intelligentinvestor.com.au. This article contains general investment advice only (under AFSL 282288).