Hedging Your Investment Bets

| January 10, 2021 | 0 Comments

The Wall Street consensus is that 2021 should be a pretty good year. With the vaccine rollout under way, the expectation is that consumers will begin to feel more comfortable doing things they’ve put off over the past few months. Travel, entertainment, dining out and other activities should see a boom as consumers return. When combined with low interest rates, improving global trade and a veritable ocean of government COVID relief spending, the conditions are set for more broad-based improvement in economic activity. That’s the base case forecast, and I think the odds are pretty good that we’ll see something like that.

Looking back at December 2019, things were also looking pretty good for 2020. The trade war with China was on a low simmer compared to the high boil of late 2018. Unemployment had hit record lows. Interest rates were relatively low and consumer and business optimism were fairly strong. Even global trade was looking up.

If someone had told me there would be a global pandemic, the global economy would effectively shut down for the better part of three months, more Americans would die in 2019 from the pandemic than all combat deaths in World War II and the stock market would hit record highs in the middle of it all, I’d have questioned his or her sanity. But that’s where we are today, and it illustrates one of the challenges with forecasting. What we think we know isn’t always correct, and what we don’t know can have a big impact.

And even if you get some things right, people and investors may not react the way you would expect. When you’re investing (or forecasting for any other activity), you need to consider what you may have gotten wrong in your analysis. What are the downside (or upside) risks to your forecast, and what would you do differently if those things happen?

Thinking about 2021, there are several downside risks to Wall Street’s base case expectations. Vaccine delivery could go a lot slower than planned. The virus could mutate further, making the vaccines less effective. Consumers, fearing additional outbreaks, could be slower to ‘come back’ than expected. Global trade could suffer as other countries experience outbreaks or are slow to roll out vaccination programs.

Or something completely different could happen. In late 2019, few people expected a global pandemic to break out. It’s possible another event could come out of nowhere to disrupt the economy in 2021.

Investors generally deal with this kind of uncertainty by diversifying their portfolios. Unless you are required to keep all of your assets in a certain kind of investment (like a foreign stock mutual fund), diversifying is a good way to hedge your bets and prepare for the known and unknown risks.

Sure, you can make a fortune riding a single stock like Amazon or Apple to riches. But if you get your analysis wrong and bet everything on a company like AOL, Yahoo! or Enron, it could go very differently. Diversifying your portfolio reduces your chances for glory and extreme wealth, but it also reduces your risk of disaster.

Looking at 2021, international stocks and smaller company stocks should benefit from stronger, broader economic activity and thus outperform the S&P 500 (mostly made up of larger companies). But if that growth does not materialize, then the S&P could still outperform. International stocks have underperformed U.S. stocks for much of the last decade, but the opposite was true in the decade before that. International stocks are a bargain compared to U.S. stocks, with more room to grow. Diversifying across different kinds of investments helps reduce the impact if one of your themes does not work out the way you thought it would.

Unless you have the luxury to wait twenty or thirty years to recover from a big loss, it makes sense to spread your portfolio around to diversify your risks. Figuring out the mix that works for you is the key to successful investing under any conditions, good or bad.

This column is prepared by Rick Brooks, CFA®, CFP®. Brooks is director/investment management and an owner of Blankinship & Foster, LLC, a wealth advisory firm specializing in comprehensive financial planning and investment management. Brooks can be reached at (858) 755-5166, or by email at brooks@bfadvisors.com. Brooks and his family live in Mission Hills.

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