LAST week, I outlined some of the key risks we face this year. These include an economic or financial setback in China and a potential domestic property downturn. This week, I'll share some specific strategies that could help mitigate them.
The first thing I've done is try to manage my own expectations. After a cracking 2009 and 2010, I'm mentally prepared for lower prices. It's in the nature of markets not to move in straight lines and, overall, the value stocks we focus on at The Intelligent Investor have performed very well, so I'm steeling myself for tougher times.
Cashed up
The second thing I've done is to increase my cash holding. At present, the family retirement portfolio I run is as cashed up as it has been for a while: a combination of cash, fixed-interest investments and positions that will deliver large licks of cash (such as RHG Group, which is about to distribute money to long-term shareholders).
Some large positions have been trimmed, as have those where the gap between the price and my estimate of intrinsic value has narrowed (either through price appreciation or changing fundamentals). For example, I've sold economically sensitive stocks such as Flight Centre and more pedestrian positions such as property investor and developer Australand, which has had a good run during the past year.
Yet I don't want to bet the whole portfolio on a bad outcome. So, offsetting a conservative cash pile is a large position in Macquarie Group, which should do well if markets continue to recover.
Market professionals have a fancy name for this combination of low-risk assets (such as cash) with higher-risk positions (which should benefit from more benign conditions). It's called a barbell approach. The cash offers some capital protection and the flexibility to take advantage of any downturn, while the portfolio would also benefit from further market rises.
I've also increased my foreign exposure, including several purchases of QBE Insurance, which generates most of its revenue offshore, to protect against the risk of a fall in the Australian dollar.
For a similar reason, I've switched the managed-fund portion of my super from a domestic balanced fund to a 65:35 split between international shares and Australian fixed interest. In the event of economic trouble, the Reserve Bank is likely to cut interest rates, which would be good news for fixed-interest investments.
Portfolio allocation
"Normally, risk mitigation is a portfolio allocation issue for me," says the chief investment officer at Intelligent Investor Funds Management, Steve Johnson.
"I don't try to avoid risks completely; I just try to make sure that the portfolio is not overly exposed to any one risk in particular.
"At the moment, though, I'm taking an active approach. Firstly, I'm moving to protect the portfolio from the China risk and, secondly, I'm trying to profit from any potential fallout. I don't want to look back in a few years' time and think, 'I thought about that but didn't act.' The main action so far has been to buy some US-centric stocks."
He has some special situations. "I've bought two US commercial property stocks [RNY and RCU] and QBE Insurance, with News Corp another potential purchase."
As for locally focused stocks, "I'm sticking to the very defensive end of the spectrum ... businesses like Spark Infrastructure and MAp Group that shouldn't suffer too much, even in a bad recession."
Senior analyst Nathan Bell says: "A quarter of my portfolio is in US dollar-denominated assets, as my concern that the Aussie dollar will suffer a sharp and substantial decline outweighs my concern that Ben Bernanke will continue devaluing the US dollar.
"With the Aussie dollar at parity with the US dollar, international brokerage expenses falling and some of the world's greatest businesses trading at decent prices, genuine long-term investors with the time to investigate overseas opportunities have a rare opportunity to increase the quality and diversity of their portfolios."
Maybe such risks will play out, or maybe they're a long way away. But, as Tony Scenna at Selector Funds Management likes to say, "If you're going to panic, panic early."
If you can't stomach the thought of a large drop in the value of your portfolio, now is the time to do something about it.
Frequently Asked Questions about this Article…
What is the 'barbell approach to risk' and how can everyday investors use it?
The article explains the barbell approach as combining low-risk assets (like cash and fixed-interest investments) with higher-risk positions that can benefit if markets recover. Everyday investors can use this by holding a cash buffer for capital protection and opportunities, while keeping select growth positions (for example Macquarie Group) to participate in upside — a mix that helps manage downside while leaving room to profit from a rebound.
Why did the author increase cash holdings and how does that help my portfolio?
The author increased cash and fixed-interest allocations to protect capital and provide flexibility to buy quality assets on weakness. Cash cushions losses during downturns and lets you act quickly if prices fall — the article notes the family retirement portfolio is unusually cashed up and includes assets like RHG Group that will deliver cash to shareholders.
Why is increasing foreign exposure recommended, and why was QBE Insurance mentioned?
The article recommends more foreign exposure to hedge against a fall in the Australian dollar. QBE Insurance was highlighted because it generates most of its revenue offshore, so buying QBE increases US/international revenue exposure and can help protect a portfolio if the Aussie dollar weakens.
Why switch a superannuation managed fund from domestic balanced to a 65:35 split of international shares and Australian fixed interest?
According to the article, the switch aims to reduce domestic currency and China risk while benefiting from potential Reserve Bank rate cuts. A 65:35 split into international shares and Australian fixed interest increases overseas diversification and gives fixed-interest protection if rates fall, which could help in an economic slowdown.
Why did the author trim positions in Flight Centre and Australand?
The article says some large positions were trimmed where the gap between price and the author's estimate of intrinsic value narrowed — either due to price appreciation or changing fundamentals. Flight Centre (economically sensitive) and Australand (property developer) were sold partly because they’d run well and reduced the margin of safety for the portfolio.
How does holding a large position in Macquarie Group fit a risk-mitigation strategy?
The article describes Macquarie Group as a higher-risk position intended to offset the conservative cash pile. If markets recover, Macquarie should perform well, offering upside potential while the cash portion protects capital during tougher times — a practical example of the barbell approach.
Which locally focused defensive stocks does the article suggest for protecting a portfolio in a recession?
The article mentions sticking to very defensive, locally focused businesses such as Spark Infrastructure and MAp Group, which the author believes shouldn’t suffer too much even in a bad recession, making them suitable defensive holdings for risk-aware investors.
How can investors act now to protect against China or market risk — should they wait or 'panic early'?
The article relays the advice to ‘panic early’ from Tony Scenna: if you’re worried about a large drop in portfolio value, now is the time to take action. Practical steps described include increasing cash and fixed-interest holdings, buying US-centric stocks and international assets, and trimming economically sensitive positions to reduce exposure to China or domestic property risk.
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