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Buying These 2 Stocks Is a Good Way to Hedge Against a Market Crash

Motley Fool - Fri Nov 24, 2023

Investors cannot avoid market downturns, they can only prepare in advance for their eventual arrival. The preparation involves two parts. One part relates to emotions, which is probably the most important, and the other comes down to the investments selected.

If you worry about a market crash, adding utilities and gold stocks to your portfolio now could help you on both fronts.

Downturns help clear out irrational exuberance

Wall Street can push stocks to extreme heights because it's easy to get carried away. It happens time and again, with the meme stock craze in 2020 and 2021 as a particularly shocking example. Even companies in bankruptcy got caught up in the drama and witnessed shocking stock price increases.

The resolution to such emotionally driven ups is a deep downturn, which usually leaves once-exuberant investors despondent, and often drives them away from whatever fad had them so excited in the first place. All of that is to say that crashes are healthy for the investment ecosystem because they flush out previous excesses.

A hand stopping falling dominos from overturning a stock of coins.

Image source: Getty Images.

That doesn't make big market downturns any easier to live through. However, if you take the longer-term view that every bear market is inevitably followed by a bull market, you might be able to better stay the course. But there's another step you can take as well to prepare for the downturns. You can diversify your portfolio so you have some investments that will hopefully hold up better during the painful periods.

This isn't a hard concept to understand, but it requires some thought to get right. For example, owning four technology stocks isn't really adding a lot of diversification. But a tech stock, a consumer staples stock, a utility, and a precious metals stock would provide a fair amount of diversification. The businesses of consumer staples stocks like Procter & Gamble(NYSE: PG) tend to hold up through good and bad times because of the necessity of things like toilet paper, deodorant, and toothpaste.

But what about utilities and gold?

Wall Street runs for the hills

Utilities, particularly those with regulated businesses, are kind of boring most of the time. Regulated utilities have to get the rates they charge and their investment plans approved by the government. In return, they get monopolies in the areas they serve and the spending and rate plans tend to come to pass no matter if there's a bull or bear market. So when times get tough on Wall Street, investors often leave the highest-risk sectors, like technology, and shift into boring areas, like utilities.

SPY Chart

SPY data by YCharts

As the chart above shows, between 2007 and 2009 the S&P 500 Index was down around 20%, while large U.S. utilities Duke Energy(NYSE: DUK) and The Southern Company(NYSE: SO) were down around 10% or so. These stocks both have some attractive features today from a business perspective that should interest investors. Duke recently sold off non-regulated utility assets so it could focus entirely on its regulated business (it became even more boring than it was before). Southern is about to complete construction of two nuclear power plants that will reduce spending needs and boost cash flows. Now add in how well they held up during the Great Recession, and investors looking to hedge against a deep bear market might want to take a deep dive.

SPY Chart

SPY data by YCharts

Although technically a third stock on this list, you might also want to consider Royal Gold(NASDAQ: RGLD). This is a streaming/royalty company, which means it provides up-front cash to miners in exchange for the right to buy gold and other metals at reduced rates in the future. Effectively, this provides investors with exposure to precious metals without their having to take on all of the risks of owning a miner (or the hassle of buying physical gold). As the chart above highlights, the Great Recession was a great time to own Royal Gold.

The reason for that is that during hard times investors often look for investments that they consider a store of wealth. That's the role gold plays for many on Wall Street, so gold-related stocks can sometimes perform in an almost opposite fashion to the market during downturns. But what goes up often goes down, so don't expect bull markets to be a good time to own a company like Royal Gold. It is probably better to have a modest exposure to the stock that you hold over the long term. That way you may have something positive to look at when the rest of your portfolio is in the red.

A little can go a long way

Whatever you do, don't run out and sell all of your portfolio and replace it with utilities and gold stocks. That's a bad idea. However, layering in some utilities and gold stocks, via companies like Duke, Southern, and Royal Gold, to diversify your portfolio can be a huge help for both your emotions and your investment outcomes. You can't avoid bear markets, but you can prepare for them, with even modest changes helping to stop you from overreacting.

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Reuben Gregg Brewer has positions in Procter & Gamble and Southern Company. The Motley Fool recommends Duke Energy. The Motley Fool has a disclosure policy.

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