Investors need to be prepared for market volatility after stocks have struggled to regain the record highs
set in May. Declining corporate profits and the possibility this month of the first interest rate hike in 10 years have made the outlook uncertain for stocks, bonds and commodities.
That’s why investors need to understand the risk and “margin of safety” in their holdings to weather uncertain times, writes Ronald Delegge of ETFGuide in a Seeking Alpha post.
“The concept "margin of safety" was originally developed in the 1930s by Benjamin Graham and David Dodd, the founders of modern day value investing,” he writes. “Graham and Dodd lived through the Great Depression so they understood the importance of investing with safety.”
The time for action is immediately if market conditions have fallen apart.
“Implementing your portfolio's margin of safety should happen when market conditions are favorable, not when it's raining cannonballs, Delegge writes.
He provided four guidelines for investors to understand their risks.
- Installing a margin of safety within your portfolio should always happen before a negative event: “Your portfolio's margin of safety - just like an insurance policy - is purchased ahead of the accident or crisis in order to protect your capital. Investing money without a margin of safety, whether done deliberately or out of plain ignorance, is negligent.”
- Building an architecturally sound investment portfolio doesn't happen by chance: Diversifying your holdings among different assets classes is necessary to prevent too much exposure to a single source of risk. “All structurally strong and healthy portfolios have three crucial parts: 1) the portfolio's core, 2) the portfolio's non-core, and 3) the portfolio's ‘margin of safety,’” he writes.
- "I'm a long-term investor" or "the stock market always bounces back" is not prudent risk management: “Some people have deceived themselves into believing their IRA, 401(k), or other investments require no margin of safety. This group of individuals generally believes they are too wealthy, too experienced, and too smart to have a margin of safety inside their portfolio.”
- Investing in gold and bonds is not appropriate for your portfolio's margin of safety: “Bonds and precious metals -- just like stocks and real estate -- are subject to daily fluctuations and can lose market value,” he writes, pointing to gold’s 42 percent drop since a mid-2011 peak.
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