How to prepare your portfolio for the next big crash

There are signs of excess everywhere in the markets. They have a very long way to fall indeed. And when they do, you must be prepared. John Stepek explains how.

Markets have a long way to fall

Seth Klarman is one of the most respected value investors out there. He's not as famous as Warren Buffett (by choice, it seems). But he has an excellent record.

So the fact that he's apparently feeling very worried about the state of the current market should give us all pause for thought.

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A portion of Klarman's most recent letter to clients has been published on the Zero Hedge website.It makes for quite sobering reading.

Klarman compares the current market environment to The Truman Show. If you haven't heard of it, it's a mildly diverting but over-rated film in which the main character discovers that his whole life has been a reality TV show stage-managed by a benign dictator.

Today, the stage managers are the world's central bankers. They've created an illusory, manipulated set for investors to gambol cheerily within, enjoying a rampant bull market.

But as Klarman notes, when the dream is shattered, markets have a very long way to fall indeed.

Timing the market is a mug's game

It's little wonder that Seth Klarman is worried. There are signs of excess everywhere in the markets: technology stocks being sold at crazy valuations; initial public offerings being slung out left, right and centre; more junk bonds than you can shake a stick at, offering lower yields you'd have been able to get on a risk-free cash Isa back in 2007 (oh, those were the days!).

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Even the biggest perma-bulls would have to admit that there have been better times to buy than today.

So what are you meant to do as an investor about all this? Well, that's where the problem lies. Ultimately, trying to time the market is a mug's game. And Klarman effectively admits that. The punchline to his letter says of the bull market:"Can we say when it will end? No. Can we say that it will end? Yes. And when it ends and the trend reverses, here is what we can say for sure. Few will be ready. Few will be prepared."

In short, many markets are significantly overvalued. That means they are running on hope. When hope runs out, they'll fall. And the ones that will fall hardest, are the ones that are most overvalued.

But as we don't know when they'll fall, the obvious solution sell everything the day before the crash and buy back in at the bottom is not a viable strategy. So what can you do to make sure you are prepared?

How to build a durable portfolio

Overall, you need a plan. You need an end goal (retirement for many of us) so you know your time horizon. You need to be saving money regularly. For most people, monthly is probably the easiest option. And you need to know where you are going to invest your money.

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On that front, there are four main points to consider.

Firstly, diversify. Don't put all your eggs in one basket, regardless of how attractive that basket looks. If your entire portfolio's success hinges on one particular outcome be that a good outcome or a bad one then you are asking for trouble. You need a mix of assets, ones that will do well in hard times, and others that will do well in good times.

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Secondly, buy stuff for the right reasons. You should buy any asset because it offers good value. In other words, the likely return you are getting on your money is attractive. (See last week's Money Morning on Warren Buffett for more on this). If your main reason for buying an asset is that you think the price is going to go up, then you're making a mistake. (Unless perhaps if you're a short-term trader, and even then, that's a whole other different world from investing).

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Thirdly, rebalance. You should know your ideal' asset allocation 45% equities, 25% bonds, 10% gold etc (that's not a recommendation, it's an example). When the allocations get out of whack with one another, you simply top up the ones that have fallen in value as a proportion of your portfolio, and leave the ones that now form too big a part of your portfolio. This ensures that you follow a buy low, sell high' methodology almost automatically.

And finally but perhaps most importantly don't allow transaction costs to fritter away your capital. There's lots of data to suggest that private investors have an unfortunate tendency to over trade and second-guess themselves. Don't do it. Make a plan, stick to it, and find the cheapest way to execute it. Most markets can be bought through passive exchange-traded funds (ETFs), but if you find an active manager you like, just make sure their outperformance can justify their charges.

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My colleague Phil Oakley has built a whole strategy around this in his Lifetime Wealth newsletter, and I think it's well worth reading. But you should be doing all this anyway. Like any good habit, it's not complicated but it is surprisingly challenging to stick to.

For what it's worth by the way, I suspect the trigger for the next big crash is rising interest rates. That's pretty much what triggers most crashes. The turning point will come when investors realise that the world's central banks can no longer afford to prop up stock markets as part of their core remit. But I'll admit, there's no obvious sign of that happening yet. I'll be keeping a very close eye on inflation and bond yields though.

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