How to prepare your portfolio for the next big crash

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.

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!).

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.

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.

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).

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.

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.

• This article is taken from our free daily investment email, Money Morning. Sign up to Money Morning here.

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  • Jezzer

    John, regarding your sentence above: “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.”, don’t you mean, “SELL some of the ones that now form too big a part of your portfolio”? Otherwise how’s it rebalancing?

  • Theilard33

    The sentence is fine. Read it over.

  • CKP

    Not convinced by the doom-mongering:

    1) These so called market experts are constantly calling some crash, they are usually ignored and then in the 1 in 20 times they are right they are hailed as genius. You are generally better off tossing a coin than listening to them. Timing the market is a mugs game.

    2) The US economy (which represents around 50% of world equities by market cap) is rocketing ahead, powered by cheap shale gas, technological innovation, recovering housing market, consumer confidence, cheap money supply. It looks pricey at current P/E but the forward P/E drops substantially. The stock markets are essentially forward looking and it is pricing in a strong recovery in the US. Something I would not bet against (following Warren Buffet’s advice).

    3) Emerging equities are in bargain territory, Russia trades at below 5 P/E and Korea around 10. China has issues but it’s importance in the grand scheme of things is overstated, although clearly they are a major consumer of basic commodities and the value of miners is geared to the economy in China.

    4) If money pulls out of equities it is hard to see where it would go. Yields on government bonds are historically low and there is already plenty of money sitting in them. Everyone is aware of the bond overvaluation caused by fear and flows are likely to be into equities not out of them.

    5) The Fed has already printed all this extra money and is not about to go re-purchasing it’s Treasuries and cancelling them. i.e. destroying money to increase the value of the dollar, why would they? Asset price inflation has happened, is happening and will continue. The recent gains in equities and real estate may only just be the beginning.

    6) Rising interest rates will create selling pressure in fixed interest securities, and money leaving bonds have no where to go – but equities/commodities/real estate. The smart money has already started shifting, hence the rises. If you are a multi-billion $ fund, you can’t just sell your bonds and leave your 10 digit bank balance just sitting in a branch of Barclays. If you did, Barclays would just go and buy assets with it anyway. The obvious safe haven is in floating rate securities but there is very limited supply of these.

    • Incomer

      Hi CKP

      Some thoughts on your comments

      1. Klarman has compounded at 20%p.a. for more than 2 decades with an average cash balance of 20% and avoids publicity. I would advise listening to him carefully.
      2. Not sure the anaemic recovery in the US can be described as ‘rocketing ahead’
      3. In five years, China has just added the same level of debt the US banking system took 100 years to add. Be careful on apparent low P/E’s.
      4. Think about this one. Someone sells a bond and they get cash. The buyer swaps cash for a bond. Ditto equities. There is not a reservoir called bonds that can be emptied in order to fill another reservoir called equities.
      5. ‘Asset price inflation will continue’. Not totally sure how you know that but you clearly do so I won’t argue.
      6. See 4 above
      Reliable equity valuations are in the top 1% of historical observations from which point you usually lose money. But maybe its different this time. Good luck.

  • Oscar Foxtrot

    John – surprised you didn’t mention shorting the market. I have short positions on the FTSE, S&P and Dow – all June expiry. All 3 are currently in positive territory. I use wide stop losses above the all time highs of each index. I believe that this is a fairly safe bet as it’s only a matter of time before markets fall – at the very least I would expect a 10% correction before June. If markets continue to rise I will add to my short positions.
    I also hold long term investments which I won’t sell even if markets fall – mainly blue chips which pay a decent dividend.
    Using short positions to hedge a portfolio is essential in the current climate.
    For the record I also hold 25% cash and 15% gold and silver bullion.

  • Marko

    Bring on the crash I say. All this easy money is getting boring.

  • CKP

    1) Klarman is indeed an impressive fellow, but has significantly underperformed the market last year. He singles out the valuations in US tech stocks which are clearly v expensive. I agree that valuations in the US are historically expensive but after the massive unprecedented QE experiment we cannot simply expect mean reversion to take place as before. All the newly printed money needs a home. Structural demand for equities have increased and thus they have rerated.
    2) The US expects to become self sufficient in energy within 10 yrs. Energy costs have plummeted. Enough said.
    3) Yes lots of risk and uncertainty in China, may cause contagion if implodes but my point is the pretty small market weighting in the all world index.
    4) Your point nicely illustrates the temporary nature of cash. When e.g. a sovereign wealth fund holds “cash” it is likely to be in the form of short dated goverment bonds. Otherwise “cash” is simply a short term loan to bank. Who will lend it or invest it. Increased supply of cash therfore causes buying pressure on assets and asset price inflation
    5) While there is no doubt that equity valuations are high, without an obvious alternative for the money in equities to switch to, there will be little selling pressure and no impetus for a sharp fall.