What works and what doesn't when you want to protect your investments so that their values do not fall? You could, in theory, time the market. That would mean purchasing riskier and higher-return investments at low prices and then selling them at higher prices before they decline in value. Unfortunately, no one has found out how do to this consistently.
The first approach to protecting your portfolio that does work is called "the shift to safety." This means selling riskier investments and replacing them with lower-paying but more stable investments. Safer investments generally provide a return by paying you up-front, such as bonds, or they have guarantees of the principal, such as certificates-of-deposit. In general, less liquid, safer investments have a higher return than more liquid ones of comparable risk.
The other approach that works is called "effective diversification." How do you measure it? The answer is through correlation. If two assets tend to move in the same direction routinely, we say that that their prices are highly correlated. If they move independently, they are not correlated. It is helpful to have uncorrelated investments in the portfolio.
A portfolio of 4 different high-tech funds is no more effectively diversified than a meal comprised entirely of 4 different flavors of ice cream. Spreading your stocks out helps sometimes. You can diversify your stock portfolio to include foreign as well as domestic companies and smaller as well as larger companies in developing as well as developed countries.
If you could find some investments that had a long-term return comparable to stocks but on a day-to-day or even month-to-month basis had a different rhythm, you would say that the investments are not correlated. Here are some types of alternative investments not very correlated to stock performance that could have a long-term return similar to stocks: real estate (there are many sub-categories here), gold and other metals, oil and gas, farm commodities, managed futures contracts, arbitraged funds, hedge funds, high-yield bonds, and loan funds.
In theory, you could construct an effectively diversified portfolio containing these alternatives with a long-term return similar to an all-stock portfolio, but without fluctuations as large as you would have from stocks alone. Here are some caveats for alternative investments: some have higher minimums for investments than stock mutual funds or require investors to be wealthier to purchase them, some are not very liquid, most are more expensive to manage, some depend on the special expertise of a money manager who may not be there forever, and many do not have long track-records on which to base investment selection. As with other investments it is hazardous to predict the future from past performance. Because of these caveats, use moderation if you choose to include these alternatives in your portfolio.
Obviously, you can use a combination of these two approaches to protecting your investment money: shift to safety and diversify all investments effectively. Even at their best, these two approaches will not work perfectly to eliminate fluctuations in return. However, you may find an approach that you are comfortable with: better managed fluctuations in investments and a return high enough to match inflation plus some money to live off.
Securities offered through Multi-Financial Securities Corporation, member FINRA, SIPC. Fischer on Finance, LLC is not affiliated with Multi-Financial Securities Corporation. Neither Multi-Financial nor Mark Fischer give legal or tax advice. Investments in securities do not offer a fixed rate of return. Principal, yield and/or share price will fluctuate with changes in market conditions and, when sold or redeemed, you may receive more or less than original investment. No system or strategy can guarantee future results.