Financial Firewalls Defend Against Volatile Markets

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With the stock market recently dropping more than 10% in a short amount of time, I’ve noticed a lot of panic in financial circles.  Beyond the fairly steep short-term loss there’s also the fear that a much more painful long-term correction may finally be starting, and stock market investors are understandably on edge.

Do you worry that your life savings are about to catch fire and burn to the ground?  Setting aside what is causing the drop, whether it portends a major correction, or even whether you should be all that concerned about it in the long run, I’d like to focus for a moment on your very real anxiety and what you can absolutely do about it.

I’m personally not worried in the slightest, and it’s not because I’m some sort of investing robot who never gets upset.  It’s because I would not have known that there’s such a major stock correction from looking at my own account balances, as a panic-inducing drop just isn’t there.  While comparing relative portfolio performances over just a few weeks is pretty pointless, in this case it’s definitely not a matter of luck but of very deliberate structural portfolio planning.  When I invested my money, I took the time to build firewalls.  

In construction, a firewall is a basic structural design element that is used to protect the whole building in the unlikely event that a portion catches fire.  A building without firewalls may be completely reduced to ash, while one with firewalls may only lose a single room.  The protective barriers that separate individual spaces take a little more planning than just throwing up drywall inside a pretty exterior, but when push comes to shove the safety they provide is incredibly important.  And the larger the building the more important they become, as losing a small home to fire is bad enough but losing an entire high-rise is a true disaster.

So how does one implement firewalls into their own portfolio?  It’s pretty simple, actually — invest in several different types of assets that don’t usually burn at the same time.  Harry Browne first introduced me to the idea of financial firewalls, so to explain how they work let’s compare a simple Total US Stock Market index fund to his Permanent Portfolio.

 

Total-US-Stock-Market-AAPermanent-Portfolio-Asset-Allocation

 

Think of a total stock market portfolio as a warehouse with a single large room full of stocks.  In contrast, the Permanent Portfolio is divided into four equal portions of stocks, long-term treasury bonds, cash (the invested variety, not the paper type stuffed under the mattress), and gold.  All of these assets respond to very different market stimuli, so think of it as having four rooms with solid firewalls in between.

If you look at the historical drawdowns data, a warehouse full of stocks may be just fine for years on end but if fire catches in one corner it can completely engulf the building like it did in 2008 when US stocks dropped nearly 40% before things cooled off.  But if the same fire starts in the stock room of the Permanent Portfolio, it’s naturally confined to only 25% of the building.  Even if the other assets do nothing at all to make up the difference, the total loss for the Permanent Portfolio in that situation is only 10%.

That loss-dividing behavior alone is a nice feature of firewalls, but it goes even further than that.  Since each asset in the Permanent Portfolio responds to different economic conditions, there’s a pretty good chance one or more of the other three assets are actually gaining value during a stock fire.  That’s how the Permanent Portfolio only lost about 4% in 2008 while the US stock market lost nearly ten times as much!  It’s also important to note that the Permanent Portfolio naturally rebalanced some of those other funds back into stocks, loading up at the sale price to re-fill the still-smoking room for the subsequent stock recovery.  Firewalls protect your other investments and allow them the opportunity to respond and redeploy as needed.

The Permanent Portfolio is certainly not the only asset allocation with effective firewalls, and there are lots of good options for all types of investors.  The most important thing to consider is that you need to think beyond simple stock diversification, as thousands of individual companies can all fall together in a market correction.  Small and value funds will have paper-thin walls, and global markets are so intertwined that even international diversification won’t always cut it.  Even corporate bonds aren’t always as effective as you’d think, as they can often swoon along with corporate stocks.  So when looking for an effective firewall in your portfolio, be sure to look for assets much more detached from stocks such as treasuries, cash, and real assets like gold, real estate, and commodities.

Find the right portfolio that contains any market fire to the comfy fire pit in the back yard, and while other investors are scrambling to save their financial homes from danger you can sit back and warm your coffee over the well-contained flames.  If the market is stressing you out, take the opportunity to turn off the financial news this week and turn your energy to something far more in your control.  How can you build protective firewalls into your own life savings?