The five worst-case scenarios you need to hedge against

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Things can change quickly

What will happen to your investments if the price of oil spikes?

Is your portfolio protected? It should be, after Monday – when I told you why you’d do well to have exposure to oil to ‘hedge’ against that very eventuality.

Now, I realise that the concept of a ‘hedging strategy’ might sound a little complicated, but like many things in the financial industry, once you’ve cut through the jargon, it’s actually pretty simple.

‘Hedging’ reminds us of mysterious, complex hedge funds, but in reality, it’s little more than diversification. I dare say ‘diversification fund manager’ wouldn’t have quite the same ring to it as ‘hedge fund manager’.

Today I’m going to show you why the oil shock we looked at on Monday isn’t the only scenario you and I should diversify against. In fact, there are plenty of different tension points that demand a hedge – and I’m going to explain five of them right now.

1. Geopolitical showdowns

As developments in Russia show, geopolitics can change in a big way from one week to the next.

I mean, today Russia is public enemy number one – and to combat Islamist separatist group ISIS, Iran has turned from most hated foe to most improbable ally.

The funny thing is that geopolitical risks, or war risks, can actually be good for many stocks. After all, war is akin to a fantastic stimulus package for some industries, such as defence.

That’s what we saw during the oil shocks of the 1970s, where problems in the Middle East caused the oil price to spike, leading to misery for the public and any industry dependent on energy. It was no bad thing for oil producers not connected to the Middle East, though. Profits went through the roof.

But stocks are, at best, a mixed bag. The one thing that really does well in these situations is gold.

Gold tends to go up during tense situations and go back into its shell as things calm.

The theory goes a little like this: the currency system that was established after the second world war relies on international co-operation. A major breakdown of trust could see the establishment of something else – and so you should hold gold until any new system becomes clear.

And if, god forbid, something nasty really starts to emerge – then really hold onto your gold.

2. Currency dramas

Closely related to geopolitical showdowns are currency dramas.

When a currency is in trouble, interest rates are often raised to protect it. You can see this in Russia, where the central bank has raised its main interest rate last week citing “the increase in geopolitical tensions” and its effect on the rouble.

What’s the problem with higher rates? Well, a fast track rate rise is the opposite of what we want as investors. The over-borrowed get smashed, and life gets more expensive for just about everyone.

To counteract this, focus on strong companies with strong balance sheets. I mentioned IG Group just last week, as a possible contender.

3. Banking crisis part 2

By now, most of us know what a banking crisis looks like.

In 2008, confidence was sapped out of the whole financial system. It was a question of which bank was next in line. Shares dropped through the floor; bonds too.

Who was safe? Which government was safe? In Europe, it ultimately led to the re-rating of many a nation’s debt. The whole thing morphed into an existential crisis.

It’s hard to diversify against that, but hard assets – ie, not financial assets – are probably the key.

To my mind, it’s why the UK housing market has bounced back so hard and so fast. Many investors have diversified away from equities and in to property.

Take a look at classic cars, arts, diamonds and even handbags – all of them beneficiaries of a failing financial system turning investors on to hard assets.

4. Inflation

Now, in many ways inflation is really a symptom of another problem. It’s a complicated story, and one we’ll look into properly another day.

For now, let’s just say there are many reasons why inflation may come back to haunt us. The key is to be diversified against it.

You can to that by investing in vice stocks (baccy, booze and betting), utilities and pharmaceuticals – which all tend to maintain pricing power in an inflationary environment.

Boring, maybe – but we’re talking about inflation hedges here.

5. Another good old-fashioned recession

Southern Europe is at risk of drifting back into recession. In fact, some countries are already there, and yet stock markets have remained resolute.

I reckon that’s all down to the reactions from the guys at the central banks. That’s one reason I remain long equities – because the guys in charge just can’t help themselves from reaching for the printing presses of monetary stimulus.

But there is a danger here. The US is currently tapering that stimulus away. And many pundits fear that by the time the tapering is finished, and we’re left with no printing at all, then the markets will take a big hit.

Will it happen? I doubt it. We know the planners can’t help themselves. To my mind, we haven’t seen the last of quantitative easing yet.

But markets will be turbulent because of that. And that means we’d like diversification.

Perhaps a global reinsurance fund such as CatCo would be useful? Investing in a fund whose fortunes roll on its global catastrophe positions is a great diversification play.

Technically, there’s absolutely no correlation with financial markets, and this particular fund has also been a handsome ‘yielder’ too.

I’ll provide some detailed plays as we go on

If we’re saying that the markets are primed for a fall, or that the next ‘black swan’ is just about to emerge, shouldn’t we be taking some kind of drastic action?

Well, no. This sort of reaction is rarely advisable. I mean, we’ve been at this point for at least five years now.

With cash paying nothing, and the general upward momentum of the markets, what you really want is a well-diversified portfolio – one that can hold out against wide and varied forms of attack.

Nobody knows what future we face. All we know is that it’s sure to be difficult.

That’s why, over the coming weeks, I’m going to tackle each of the scenarios above in more detail. Watch this space.

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