From its beginning in the overheated Asian markets to the dramatic drop in the Dow, Tuesday's (February 27) plunge in stock prices came as a surprise to many traders. Although unusual — there have been only 29 trading days since 1950 that have resulted in such large percentage losses for the S&P 500 index — anomalies such as these will occur. Investors should consider the following in determining whether their portfolios are well-positioned for future sell-offs.
1. Often, the diversification benefit of international investing is only experienced when stocks are going up. Absent the benefit of currency diversification, a portfolio that is overly spread among global bourses may end up generating significantly more volatility than expected if stocks head south.
2. The best type of diversification can be gleaned from investing in disparate asset classes. Fixed income investments, for example, fared well during Tuesday's debacle, a common occurrence during market dislocations. In addition, fund of hedge funds seemed to weather the storm fairly well, and many of them will post gains in February.
3. If the slowdown in housing spreads from the sub-prime lender to the rest of the market, resulting in more expensive corporate credit, the sell-off may continue. Advisors should keep abreast of credit spreads, and adjust positions accordingly.
