Make Sure You Use This Portfolio “Safety Switch”

The best way to make life-changing profits is to buy stocks in overseas growth markets.

But before you invest a single dime in stocks you need to know some investment basics.

One of these basics is proper diversification.

Diversification is important because although stocks offer the greatest potential rewards for investors, they come with risks attached.

Put simply, stocks go up as well as down. And proper diversification acts as a “safety switch” when stocks go down.

If you doubt what I’m saying, rewind to 2000 or 2008 when stock markets crashed…first after the dot-com bubble and then after the subprime mortgage blow-up.

Investors who were mostly invested in stocks suffered big losses…in many cases, losses they never recovered from.

The lesson to learn is that being diversified over geographical regions won’t do you much good.

As you can see from the chart below, the S&P 500 (red line on the chart) and emerging market stocks (green line on the chart) tracked each other closely during the recent stock market crash and the post-crash rally.

So just investing in stocks across geographical regions doesn’t ensure proper diversification. The less that any single bad event of any kind can affect your portfolio, the more diversified you are.

As you can see, if you had been holding an “all stock” portfolio in 2007/08, you would have been badly affected by a single event…even if you had been diversified across regions.

This wasn’t always the case. In the past, geographical diversification was a good way to ensure against major portfolio losses.

But since the financial crisis, the markets have been driven mainly by something called the “risk on/risk off” trading pattern.

In “risk on” mode – when investors are optimistic – stocks, commodities rise across the board. In “risk off” mode – when investors are running scared – commodities and stocks fall across the board.

That’s not to say that geographical diversification isn’t important. It is. As debt loads and sluggish growth rates in America, Europe and Japan become more of a drag on stock prices, you’ll want to add more exposure to high growth, low debt emerging economies.

The point is geographical diversification alone won’t steer your portfolio to safety.

So what does a proper “safety switch” look like in a world defined by the “risk on/risk off” trading pattern?

And how can you be sure your portfolio is insulated from a catastrophic stock market crash like the one we experience in 2008?

The first port of call is gold.

Some people think of gold as a commodity. But I prefer to think of it as “honest money.” Gold is cash that holds its value in other words.

Another important diversifier is cash itself. Cash in the bank  doesn’t fall in value when stock markets fall. So it’s another important element of a well-diversified portfolio.

Emerging market bonds are also a good way to diversify your portfolio.

One easy way to gain exposure to emerging market bonds issued on local currencies is through the WisdomTree Emerging Markets Local Debt ETF (NYSE:ELD).

ELD invests in bonds issued by Brazil, Chile, Colombia, Mexico, Peru, Poland, Turkey, South Africa, Russia, Malaysia, Indonesia, Philippines, Thailand, and South Korea.

This ETF has a stated distribution yield of 4.78%. And it charges fees of 0.55%. So it is a good way to add some income into your portfolio as well as currency and portfolio diversification.

By adding these non-stock market investments to your portfolio, you have a much better chance of surviving another big downturn in stock market investments.

They are your “safety switch” when the market’s mood turns ugly. And I recommend you include them in your global portfolio.