One of the key features of this market collapse is that everything has fallen: stocks, bonds, gold and even bitcoin.
This is expected by those of us who have seen these market collapses in the past, but newbies are baffled. So, let’s try and understand why.
The ideal portfolio is a diverse one. It’s not just diverse in the stocks you own, but also in which geographies and sectors these companies operate in.
Further diversification can be had by adding commodities, property stocks and cash, or cash-like assets such as bonds.
This will mean that a problem in one part of your portfolio, for example holding an oil stock amid Saudi Arabia and Russia’s oil price war, won’t cripple your entire portfolio.
This works perfectly well under normal market conditions, with much of your portfolio moving higher while one or two parts of it may be under pressure.
Here we must look at what is referred to as correlation. Where one asset’s price stumbles and the rest keep growing, we use the mathematical term uncorrelated.
The formula used to determine correlation spits out a figure of between -1 and 1, with 1 being correlated and -1 meaning inversely correlated (one goes up while the other falls). Add to this is the mid-range of 0, which means no relationship between the two assets. So, a diverse portfolio would be around the zero level, albeit practically it is probably slightly positive.
But when it gets truly gruesome, as we’re seeing right now, everything becomes correlated at 1 as all asset prices fall.
In the first instance when markets get spooked the only safe place is cash, and in order to get that cash you must sell assets. Cash is the one asset that does not lose its value in a crisis, ignoring inflation for the sake of simplicity.
But then why did gold and bitcoin decline? They’re supposed to be safe havens.
The answer is again simple. Gold is great for when you’re worried about the future. But when that worry starts to translate into reality and starts happening, you need cash. You can’t pay the bills with gold bars.
The same applies to bitcoin. Regardless of what you believe about cryptocurrencies, when people want or need cash, they’re going to sell and send the price lower. Now, as the panic subsides, they may rally again, and as I’m writing this, the price of gold is moving higher.
Adding to the need for cash are margin calls.
This is only in the realm of traders who use derivatives. What happens here is that traders buy or sell stocks but pay a deposit of 5% to 15% of the total value of the stocks.
When the trade moves sharply against them, they can lose more than the deposit and now they suddenly need cash to settle those margin calls and subsequently they must sell assets to raise the cash.
So how do we truly protect our portfolio from a market collapse?
Cash. It is that simple. My cash holding has not lost one cent. In fact, it has increased a few cents due to interest received on the money.
There are two piles of cash we need to always have.
The first is an emergency fund. At least three and ideally six months’ worth of living expenses. This would be to cover you in the case that you lose your job or have an unexpected and large expense.
The second pile of cash is your cash needs for known one-off expenses over the next three years at a minimum; five years if you really want to be safe. This could be a planned wedding in a year or two, your money for living on during retirement or just a deposit on a car or a house.
Because this money is in cash, when everything is falling, you’re able to cover any emergency and expected large expenses. The last thing you want to be doing right now is having to sell because you need cash.