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August 24, 2017

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Market Correction Ahead – 3 Ideas To Protect Your |

We all like surprises, some more than others, but when it comes to investing that’s the last thing you want‚Ķis a surprise. A surprise market correction, a surprise market crash‚Ķthose are the types of surprises that can really de-rail your financial goals and cause you unwanted stress and worry.

Without a doubt, the market been HOT this year, but the questions yet to be answered are, how much higher can it go before it fizzles out? How do I protect my portfolio before reality gets priced in and the market corrects?

The first thing that’s important to understand when we are in this kind of a bull market is to not let our judgment become clouded and succumb to the”hot hands fallacy.” The “hot hands fallacy” applies primarily to sports such as basketball and baseball but also to gambling and investing‚Ķthis dangerous phenomenon is the fallacious belief that a person who has experienced success with a seemingly random event‚Ķhas a greater chance offurther success in additional attempts. In other words, when you experience a sequence of high returns in the stock market like the period during the 1990s tech bubble‚Ķit clouds your judgment in that you get sucked into believing that you will have an equal or greater chance of success in the future‚Ķsaid simply this is hindsight bias.

Why do losses matter anyway ‚Äì the market always comes back, right? Well, it’s important to understand how losses can adversely affect your portfolio, for example:

Original Loss Return Required to Recover10% 11%20% 25%30% 42%40% 67%50% 100%

As Warren Buffet wisely said, “Only when the tide goes out do you discover who’s been swimming naked.” Trust me, the last thing you want is toget caught investing “naked” when this market throws a temper tantrum, so here are 3 different investment ideas for crash-proofing your portfolio.

Should You Add Some Protection Into Your Portfolio?(photo credit: Shutterstock)

1st Idea for Crash-Proofing Your Portfolio: Use True Diversification

The foremost and timeless idea is to properly diversify your portfolio. You may be thinking well duh, of course I know I need to diversify my portfolio, doesn’t’ everyone? Well, hold that thought for a second because there are different levels and different types of diversification. We all know the basic approach to diversification is to own many stocks instead of just one or to own many mutual funds instead of a couple‚Ķbut that’s simply not advanced enough if you want to crash-proof your portfolio.

True diversification can only be achieved through what I describe as “risk differentiation.” For instance, if all you own is mutual funds‚Ķeven if they are diversified among stock and bond funds‚Ķ they aren’t truly diversified because they are still closely related from a risk perspective‚Ķthat is simply because mutual funds, no matter what they own, are traded on the stock market. This correlation risk is especially noticeable when the market corrects or crashes.

The solution is that you must own dissimilar investments‚Ķinvestments with different types of risks. That’s “risk differentiation.” A “diversified” mutual fund portfolio is like ice cream. When you go to your favorite ice cream shop they offer all kinds of flavors right? But the base ingredient is the same – it’s all still ice cream. If all you own is stocks or mutual funds the base risk is the same, so you can’t expect to crash proof your investment portfolio unless you employ “risk differentiation,” which requires using different types of investments with different types of risks so no one thing‚Ķlike the market crashing‚Ķcan take your entire plan down with it. Said in a more technical fashion, “risk differentiation” is asymmetrical risk management.

Tiger 21, a peer-to-peer investor network (members must have a verifiable investment portfolio worth at least $10 million) follow this “risk differentiation” approach to diversification. According to a recent CNBC interview Tiger 21 members are seeking investments that are NOT correlated to the stock market‚Ķpossibly a sign that the “smart money” thinks the market is overbought, overdue for a pullback, and better opportunities lay elsewhere.

2nd Idea for Crash-Proofing Your Portfolio: The Total Return Approach

The Total Return Approach to investing is designed to help reduce surprises and consequently stress and worry. If you think about any type of investment, be it mutual funds, stocks, real estate, you name it, the total return that you earn is only comprised of two components.

Take income-producing real estate for example. Imagine you own an apartment building‚Ķyou earn rent from your tenants, right? That cash-flow is called the “yield.”

You have more control over the yield because you determine who gets to rent and the amount of rent they have to pay. Your apartment complex is also worth something, right? That’s called the property value‚Ķwhich changes everyday depending on the real estate market.

Your investments Total Return is made up of the monthly rent you receive (called the Yield) and the value of the property…

If you think of it as a simple math formula:

Total Return = Yield +/- Market ValueThe same holds true for stocks…Total Return = Dividend Yield +/- Stock ValueAnd bonds…Total Return = Interest Yield +/- Bond Value

Because there are only 2 factors that make up your total investment return, which of these two factors do you have control over the most? The yield…or the Market Value?

The answer is clear‚Ķno one has control over the market…whether it’s stocks, funds, or real estate‚Ķ but we do have more control over the yield. So, if you want to increase your chances of hitting your ideal investment return each year, you should focus more on what you have control over‚Ķthe yield.

Think of it this way‚Ķsay you’re trying to make 7% a year. If your portfolio is only yielding 1% then you’re left with the hope that your investments grow by 6% per year. The Total Return Approach is designed to reduce that uncertainty and you can accomplish this by focusing less on hoping you hit a target return and focus more on the yield because you have more control and certainty over what yield you’re earning on your portfolio.

If you’re trying to make 7% per year and you’re yielding 5% then you only have to hope that your investments grow by 2%…which is likely to be more achievable.

3rd Idea for Crash-Proofing Your Portfolio: The Prudent Investor Rule

This is something so powerful, yet so simple you can apply it right now. This could be the best preventive medicine to better protect your life savings ‚Äì and that is to follow what is called the ‘Prudent Investor Rule.’

This rule has been around for over a century and its purpose is to help you understand how much a prudent investor would have at risk and how much you should have protected from market losses.

This rule states that you take the number 100 and subtract your age. The remainder is the maximum a prudent investor would have in the market. So, for example, if you’re 55 years old (100 – 55 = 45%). 45% is the amount a prudent investor should have invested in anything that is affected by the markets‚Äì like stocks and mutual funds. (Note that bond mutual funds are traded on the stock market, so they count as ‚ÄòRisk Money’)

Think about this simple and brilliant advice for a moment. Say your investments experience a normal correction‚Ķand you only lose 15%. If you have $600,000 and you own a diversified mutual portfolio you would lose $90,000 BUT if you apply the ‚ÄòPrudent Investor Rule’ you would only have $225,000 exposed to market losses‚Ķand you would effectively have 45% less risk in your portfolio.

As Ben Franklin said, “By failing to prepare, you are preparing to fail.” The markets always seek equilibrium‚Ķthey always revert to the mean, so with the markets near all-time highs now is the time to prepare a plan to protect your portfolio. As the old saying goes, it’s better to be safe than to be sorry.