Personally, I like air shocks the best, but we're not talking about pickup trucks here. Every long-term portfolio needs to have good shock absorbers. Shocks can come out of the blue and are difficult to develop hedges for. But some shocks are foreseeable, you just don't know the timing for them. Such an item is the current situation in the Middle East. As I have been noting in my posts, we're going through a danger period with Israel and Iran the next 2 months or so where there is a greatly higher chance of an Israeli strike. The further we go into 2010 with no strike, the more likely a deterrence strategy is going to be implemented.
Doing a pre-emptive bombing on Iran's nuclear plants poses many serious problems for Israel. Radioactivity from the aftermath could drift over the densely populated areas next to Iran and kill millions causing severe geopolitical and public relations problems for the Israelis for many years into the future. Recent polls, even in Israel, reveal that a majority think that even if Iran gets nuclear weapons, they won't use them. A strike would likely snuff out the fledgling global recovery we have worked so hard to get going making Israel public enemy #1, even though polls show most Americans would back an Israeli strike. That opinion could change as the complications of a strike wore on. On the other hand, if Israel were to allow Iran to build some nuclear weapons, they could simply wait for their first attempt to use them and respond, probably with some whole-hearted U.S. help, and pulverize Iran into oblivion with all the world cheering them on and designating not only Iran, but all of Israel's enemies as public enemy #1. But there is no telling how many cities and lives they may have to give up in the process.
I think pre-emption is the more likely of the two, but how do you design an investment portfolio until we know how this all plays out? All cash isn't a bad option, but for, say a mutual fund where you need to maintain an exposure to the markets, you need shock absorbers. Although the touchy situation with Iran has been well know by the markets for years, they have become a little desensitized to it with repeated cries of wolf. You hear or read little about it on CNBC or the other financial media, even though it perhaps is the most powerful market moving thing that should be being analyzed right now.
To take a stab at such analysis, let's take the 9/11 attacks as our sample shock inducer. These attacks had a lot shock value. It was the first time in history the U.S. suffered a military attack on its soil. The stock market had to be closed down for days. The next Sunday, churches were filled. We didn't know precisely what countries were to blame, but we knew there was gonna be trouble in the Middle East. The two big things that come to mind to guard against such shocks are oil and gold, in that order. So load the boat with oil stocks? No. Why? Look at the reaction: (click to enlarge)
Oil stocks tend to follow strong market moves too much, even though the oil price did go through a spike (that quickly normalized). It was a much different reaction with the gold stocks:
Gold and gold stocks reacted strongly in the opposite direction. Both these reactions were short lived before gold and oil returned to the bull, bear, or sideways markets they were doing before the attacks. We can thank our lucky stars if market reactions to an Iran strike are so brief.