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LONDON -- What is holding the markets back? What keeps professional investors awake at night?
A recent report from the Economist Intelligence Unit sheds some light on both those questions. No less than 71% -- that's nearly three quarters -- of institutional investors in the U.S. and Europe fear that an extreme "tail risk" event -- essentially, a catastrophic shock -- is likely or highly likely to occur within the next 12 months.
The events seen as most likely to plunge financial markets into chaos are global recession, recession in Europe, a break-up of the eurozone, or a Greek exit from the euro. There is little doubt which region is seen as the biggest risk to financial stability.
Further down the list, a U.S. recession, failure to avoid the U.S. "fiscal cliff," a major bank insolvency, or a hard landing for the Chinese economy are all seen as significant risks. Surprisingly, possible military conflict in the Middle East does not get a mention.
The good news for investors is that if politicians in Europe, the U.S., and China can steer their economies around these specific risks, then the potential upside looks promising. So the argument to stay out of the market altogether is weak.
But what can investors do to protect themselves against the downside risks?
Diversification, of course, always make sense. The EIU report shows that institutional investors still use diversification as one of the main techniques to mitigate risk, despite having little faith that it provides effective protection against tail risk. Asset classes have tended to move in tandem since the financial crisis of 2007 to 2009.
Institutional investors can also buy derivatives to protect against volatility. That's difficult for private investors to access, but there are some other strategies worth considering.
Cash or gold
Holding cash has an opportunity cost, especially when interest rates are so low. But it also has an opportunity value if markets fall: You are able to purchase shares at reduced prices.
An alternative to cash would be to hold gold in a liquid form through a listed gold ETF such as ETFS Physical Gold (LSE: PHGP.L ) , denominated in sterling for U.K. investors, or SPDR Gold Trust (NYSE: GLD ) for U.S. investors. With interest rates low, the opportunity cost of holding gold as opposed to cash is also reduced.
And while gold's traditional safe-haven asset status has come into question, as the metal has tended to move in correlation with other risk assets since the financial crash, it should certainly offer better extreme downside protection than equities.
What's more, money printing by the Federal Reserve should at least underpin the long-term price of gold. Historically, there has been a strong correlation between the U.S. monetary base and the gold price. SPDR Gold Trust is up 9% since the middle of August, when markets began to anticipate QE3. And gold may yet come into its own if Western governments' dependence on the money-printing presses eventually generates inflation.
On the defensive
Holding traditional defensive stocks, particularly those whose value is underpinned by a relatively high yield, is another way of mitigating downside risk. I would particularly favor companies with low exposure to the eurozone, as that's the most likely ground zero in any future crash.
Pharmaceuticals, tobacco, and consumer staples were especially resilient in the last financial crisis. These three sectors are each represented in the FTSE 100 by two principal companies.
My preference would be for GlaxoSmithKline over Astrazeneca, as the latter has yet to show how it will overcome its impending patent cliff. In the other two sectors, I prefer British American Tobacco and Unilever over Imperial Tobacco and Reckitt Benckiser, as the latter two have bigger exposures to Western Europe and less to emerging markets than their rivals.
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