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My current investment strategy involves having 20% as liquid cash, 30% as bonds (aggregate bond fund), and 50% as a mix of domestic and international equity. The stock portion is invested via index funds.

My problem is the recent run-up in the market but the question is applicable in general. When a market runs up with what one thinks is not due reason, what are some assets to have in one's portfolio to make a possible crash softer without giving up too much gains.

Some loss of gain potential is obvious if I were to put more towards bonds than stock, or more in cash. Both of these examples though may suffer in case of US Debt default. Is being completely crash proof not possible without taking a high risk and betting that the crash will happen? What would be a good way to measure the potential loss from missing a rally vs potential loss of staying in?

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    What would be a good way to measure the potential loss from missing a rally vs potential loss of staying in? This could likely make an interesting question on its own. – George Marian May 2 '11 at 18:06
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One approach is to invest in "allocation" mutual funds that use various methods to vary their asset allocation. Some examples (these are not recommendations; just to show you what I am talking about):

  • Hussman Strategic Growth / Hussman Total Return are funds that use backtested statistics and indicators to vary allocation and hedging
  • PIMCO has several allocation funds, such as All-Asset, All-Asset All-Authority, and Multi-Asset, based on their macro views
  • There are a number of "value investor" funds that do more bottom-up allocation decisions, such as FPA Crescent, Fairholme Allocation
  • There are also value funds that are just conservative in stock selection, though they stick to mostly stocks; examples might be Sequoia (very blue-chip high-margin companies) and Royce Special Equity (avoids leveraged / low-margin companies). These have done better in downturns in the past and lagged on upswings sometimes.

A good way to identify a useful allocation fund is to look at the "R-squared" (correlation) with indexes on Morningstar. If the allocation fund has a 90-plus R-squared with any index, it probably isn't doing a lot. If it's relatively uncorrelated, then the manager is not index-hugging, but is making decisions to give you different risks from the index.

If you put 10% of your portfolio in a fund that varies allocation to stocks from 25% to 75%, then your allocation to stocks created by that 10% would be between 2.5% to 7.5% depending on the views of the fund manager. You can use that type of calculation to invest enough in allocation funds to allow your overall allocation to vary within a desired range, and then you could put the rest of your money in index funds or whatever you normally use.

You can think of this as diversifying across investment discipline in addition to across asset class.

Another approach is to simply rely on your already balanced portfolio and enjoy any downturns in stocks as an opportunity to rebalance and buy some stocks at a lower price. Then enjoy any run-up as an opportunity to rebalance and sell some stocks at a high price.

The difficulty of course is going through with the rebalance. This is one advantage of all-in-one funds (target date, "lifecycle," balanced, they have many names), they will always go through with the rebalance for you - and you can't "see" each bucket in order to get stressed about it. i.e. it's important to think of your portfolio as a whole, not look at the loss in the stocks portion. An all-in-one fund keeps you from seeing the stocks-by-themselves loss number, which is a good way to trick yourself into behaving sensibly.

If you want to rebalance "more aggressively" then look at value averaging (search for "value averaging" on this site for example).

A questionable approach is flat-out market-timing, where you try to get out and back in at the right times; a variation on this would be to buy put options at certain times; the problem is that it's just too hard. I think it makes more sense to buy an allocation fund that does this for you. If you do market time, you want to go in and out gradually, and value averaging is one way to do that.

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Nobody has a "crash proof" portfolio -- you can make it "crash resistant". You protect against a crash by diversifying and not reacting out of fear when the markets are down.

Be careful about focusing on the worst possible scenario (US default) vs. the more likely scenarios. Right now, many people think that inflation and interest rates are heading up -- so you should be making sure that your bond portfolio is mostly in short-duration bonds that are less sensitive to rate risk.

Another risk is opportunity cost. Many people sold all of their equities in 2008/2009, and are sitting on lots of money in cash accounts. That money is "safe", but those investors lost the opportunity to recoup investments or grow -- to the tune of 25-40%.

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