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Can Your Portfolio Survive The Coming Bust?

In case you’re alarmed, I have to point out I have no special insight into when the next economic, housing, or stock market bust would occur. Getting the timing right on such issues is notoriously tricky and even the ‘experts’ are sometimes no better than coin-flips.

That said, I do know that a bust will happen sometime down the road (I just don’t know when): Booms and busts are just natural and part of the system.

And, herein lies the questions: If we don’t know (and can’t tell) when a bust would appear, should we still invest? And if we were to invest, how could we ensure that our portfolio can survive any coming busts?

For the first question, we could really turn to how the stock market has performed historically. Since 1988, the Straits Times Index (SGX: ^STI) has had its fair share of booms and busts over the years. In the past 26 years, the index had dropped by more than 20% from its peak-to-trough in each calendar year in 8 separate years (how’s that for busts?) but it’s still achieved a 284% climb from where it was at the start of 1988 to 3,200 points today.

In the USA since 1928, the S&P 500 Index has, on average, dropped from a recent high by 15% every two years, 20% every four years, and 30% every decade. That’s painful. But American stocks have also increased by more than 10,000% in value since 1928. Given enough time, unpredictable busts can be but a distant memory whose deleterious effects on our wealth can become miniscule.

As for the second part of our question, we can turn to Charlie Munger, the venerable long-time business partner of the legendary investor Warren Buffett. Munger once talked about risks in the market: “Risk to us is 1) the risk of permanent loss of capital, or 2) the risk of inadequate return.”

If we think along those two lines Munger mentioned (which are essentially intertwined), we could help inject some steel into our portfolio to withstand adverse shocks from all kinds of busts.

To lose capital permanently, one of the easiest ways would be to see the companies we are invested in go bankrupt. For that, we could turn to companies’ balance sheets to get a feel of how much financial risk they are taking on. All things equal, high levels of debt should warrant more caution from investors.

Despite the simplistic nature of such an analysis, as the late Walter Schloss (himself an exceptional investor) put it: “I like to look at the balance sheet and I don’t like debt because it can really get a company into trouble.” When companies have no or negligible levels of debt and are able to produce meaningful cash flows from their operations consistently – examples include stock exchange operator Singapore Exchange (SGX: S68) and aircraft engineering outfit SIA Engineering (SGX: S59) – the risk of them going belly up goes way down even in very tough economic busts. After all, no one ever went broke with no debt.

Buying shares that are way over-valued could be another way to lose capital quasi-permanently when stock markets as a whole go south; during market collapses, it’s often the richly-valued shares that tend to get hit the hardest.

In any case, shares that are priced for perfection can also make for poor investments even in normal investing climates. For instance – and I know it’s a dead horse I’ve flogged umpteenth times, but it’s such an instructive example – shares of Blumont Group (SGX: A33) were valued at close to 500 times earnings and 60 times its book value early last October before its stunning collapse of more than 90% in just three trading days; the company’s ridiculous valuation just couldn’t hold up. Considering that an investor needs to make a 1,000% return to recoup a 90% loss, it’s hard not to classify losses in Blumont’s shares for investors who bought at its peak as being near-permanent.

In addition, buying expensive shares can also result in inadequate returns, which deals with Munger’s second point regarding risk. Imagine you had a 7-year time horizon for your investments back in 1 March 1999. At that time, Raffles Medical Group’s (SGX: R01) shares were going for S$0.55 each and valued at 61 times trailing earnings. Over the next seven years, earnings at the healthcare operator grew by 187% but its shares were flat as it last traded at S$0.55 on 1 Feb 2006. Overpaying for growth can result in the real risk of inadequate returns for investors – or in RMG’s case, no capital gains.

Investing has been said to be a loser’s game where investors should really concentrate on avoiding losers rather than focus on finding winners. In other words, if we avoid the big mistakes, even tiny winners can do wonders for our portfolio. So, before you invest any of your hard-earned cash, think hard about your portfolio’s ability to withstand market crashes. You won’t know when these crashes will hit the markets like a speeding trailer, but you can bet on it that it will one day. Be prepared.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing owns shares in Raffles Medical Group.