How To Protect Your Portfolio In A Time Of War

Stéphane Renevier

4 months ago5:00 mins

How To Protect Your Portfolio In A Time Of War

As if markets weren’t already struggling enough with the threat of higher inflation and rising interest rates, now war has broken out between Russia and Ukraine. So if you’re one of the many investors casting a wary eye toward this geopolitical crisis, here’s how to reduce the risk in your portfolio.

Build a cash buffer

The simplest and most effective way to reduce risk in your portfolio is to sell some of your assets and build a cash buffer. That’ll not only protect your financial capital if things get worse, it’ll also help preserve your emotional capital. In other words, it’ll allow you to more clearly see the opportunities that will eventually appear. It’s difficult to see the case for buying stocks after you’ve suffered a 60% loss, after all.

Once you have this buffer in place, you can start putting together a shopping list of stocks you like and monitoring their prices closely. Markets often make strong moves for non-fundamental reasons in times of conflict, which could create some great value opportunities for those on the lookout.

The biggest drawback of this approach is that you might end up staying in cash for too long, with inflation slowly but surely eroding the value of your capital. So make sure you define in advance when and how you’ll deploy your cash back into markets.

Rotate to more defensive positions

If you’re adamant about remaining fully invested, think about rotating your riskier positions into more defensive ones. For stocks, that means rotating away from speculative growth names and consumer discretionary stocks and into consumer staples, healthcare and gold mining stocks. For bonds, it means favoring government debt over riskier corporate debt, and US government debt over international debt. You could also alter your long-term asset allocation mix, reducing your stock holdings and increasing your holdings of bonds or gold.

Now, it’s important to be aware that this approach won’t protect you fully against a significant crash: defensive stocks might not go down as much as cyclical ones, but they’re still likely to go down. Then again, losses have a bigger impact on your P&L than your profits do (a 50% loss requires a 100% gain to break-even), so the more you can reduce them, the better.

Bring balance to your portfolio

The conflict has significantly increased the downside risks to economic growth (particularly in Europe), inflation (through higher energy prices), and interest rates (through higher inflation). Building a portfolio for an uncertain environment should maximize the chances you’ll make it out alive, whatever happens next.

So if you don’t own inflation protection, make sure you buy assets like real estate, infrastructure, and commodity producers. To protect against higher rates, hold some banking and basic resources stocks. To hedge against lower growth, make sure some of your portfolio is allocated to US government bonds. And at the risk of the apocalyptic scenario of lower growth and higher inflation, hold some gold and treasury inflation-protected securities (TIPS).

Here’s broadly how hedge fund manager Ray Dalio builds a balanced, “all-weather” portfolio: 30% in global stocks, 7.5% in commodities, 7.5% in gold, 40% in long-term US treasury bonds and 15% in intermediate US treasury bonds. Remember, it’s also important you rebalance your portfolio whenever significant price moves – like the recent ones in the commodity markets – take your actual allocation away from your targets.

The main disadvantage of a more balanced portfolio is that you’re likely to do okay in almost all scenarios, but you’re unlikely to do great in any of them. That makes the approach more suitable if you’re not sure what will happen next, and don’t want to try to identify specific risks and a likely outcome.

Hedge specific risks

If, for whatever reason, you don’t want to touch your portfolio, you might still be able to protect your investments by implementing a few strategic hedges: identifying a specific trade that should perform well in a given risk scenario.

So you could hedge the risk of a sharp fall in the market by shorting the S&P 500 or the Nasdaq. As soon as you think the threat’s passed, all you have to do is close your hedge and you’ll be back with the same portfolio as before. You could hedge other risks too: the risk of higher inflation by buying TIPS, commodities, or energy stocks, or even risks specific to the Russia-Ukraine conflict by buying agricultural assets or shorting the euro-yen (we’ve shared a few more out-of-consensus ideas here).

Of course, hedging your risk requires you to take a more active approach to investing. And if your hedges don’t work as you expect, you could suffer a double whammy of losses. So this strategy isn’t for the faint of heart…

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