After the 'flash crash' and world debt crisis, is it time to risk proof portfolios?

Amid the world debt crisis and 'flash crash,' it pays to learn about 'limit orders' and bond risks.

By , Staff writer

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    Traders James Marchese and Mario Florio, center, react in the S&P 500 futures pit in Chicago on May 6. The stock market had one of its most turbulent days ever with some US stocks losing half their value before bouncing back. The 'flash crash' and world debt crisis have left investors wondering how to protect their funds.
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Just when it seemed as if American investors were getting comfortable again, with the economy in recovery mode, they've gotten a couple of sharp reminders that investing still carries big risks.

First came rising worries about the debt crisis in Greece, and the related fiscal challenges of Europe's monetary union.

Then, on May 6, came the freak "flash crash" in the United States, with some stocks losing more than half their value and then gaining most of it back – all in about 20 minutes. Even some mainstream exchange-traded funds (ETFs) were caught up in the mysterious plunge.

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As if all that's not enough, the price of gold has been hitting record highs. That's typically a flight-to-safety move – or a sign that inflation is on the way in traditional currencies like the euro and the dollar.

What's going on here? Is it time to take some steps to safeguard your nest egg?

"There's no question that inflation is a big risk" as governments and central banks continue to prop up economies from Greece to the US, says Peng Chen, president of Ibbotson Associates, a Chicago firm that researches asset allocation.

Despite the worrisome signs, he and other financial experts don't advise heading for the hills in a flight from risk right now. For one thing, millions of people with retirement accounts have already done that – moving money out of stocks into bonds and cash. After a year of recovery in share prices, they were just starting to migrate back into stock mutual funds when the latest turmoil flared up.

But it's a good time for investors to give their game plans a reality check – in areas including stocks, bonds, and alternatives.

"One thing's for sure: Over time bonds are going to be safer and stocks are going to be more risky. Bonds will outperform cash. Stocks will [probably] outperform bonds," Mr. Chen says.

He says investors should rely on diversification among those core asset classes, and on a long-term view that takes some volatility in stride. Even "safe" bonds could be hurt by inflation worries, he adds.

Alternative investments like gold or commodities can offer some inflation protection, but financial experts warn that those investments can experience sharp price swings – and thus should make up at most a small percentage of the typical portfolio.

Limit orders for your ETF

Financial pros offer one very specific safety tip from the May 6 flash crash – when some investors saw transactions occur at share prices that varied by 50 percent or more within the space of minutes. Don't just assume that markets are "efficient," with share prices that always reflect the rational consensus of what assets are worth.

You can place buy or sell orders on an ETF with a limit on the transaction price. If the limit you place is not too ambitious (too far below the current quote), the trade should still go through on the day you place the order.

Among stocks, diversification should include not just overseas "emerging markets" but also small-capitalization firms, argues Richard Bernstein, who heads Richard Bernstein Capital Management. "For more than two years, US small-cap stocks have outperformed Chinese shares" as well as [those of] large US firms, he wrote to clients earlier this month.

Mr. Bernstein expects that outperformance to continue, based on the idea that the return on capital is highest where capital is scarcest – and that many small firms are having trouble raising capital now.

If stocks tend to offer the highest returns, bonds offer an important cushion of safety. In the financial crisis, bonds were relatively stable even as stocks were losing more than half their value. But an economic recovery or bad news (government deficits and inflation) could cause lenders to demand higher interest rates. Today's bonds, with their low yields, would fall in price .

Money market funds or bonds?

Should investors move out of long-term bonds and into money-market funds or short-term bonds for now?

That has its own risks, says Vanguard Group in a recent analysis. Investors often fail to predict where credit prices are headed, or when. So moving into cash until an expected interest-rate hike may not pan out. Moreover, the study predicts that falling bond prices will be more than offset, over time, by income gains as yields rise. A mix of bond durations may be best.

Related:

SEC unveils 'flash crash' fixes, but Dow plunge still mysterious

World debt crisis: eight reasons you should care

Why Greek debt contagion is roiling global stock prices

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