Meredith Whitney unwittingly provided a textbook example of headline risk last November when she predicted defaults amounting to “hundreds of billions of dollars” in municipal bonds.
The comments made by the celebrity analyst during a “60 Minutes” interviewed triggered billions of dollars in selloffs of municipal bond holdings that has continued for 29 consecutive weeks, according to Lipper U.S. Fund Flows. Investors fleeing municipal bond funds sold shares at sharp losses, ignoring the chorus of voices protesting Whitney’s claims. The panic selling created buying opportunities for investors scooping up muni bonds at discount prices.
The headlines resulting from Whitney’s infamous interview frightened many investors into making emotion-based decisions. Muni bonds are not the only financial products subject to “headline risk,” a phenomenon that induces the average investor to buy and sell at the worst possible times.
Reports of a management shakeup or corporate scandal can cause a company stock to drop, even if the rumors later prove to be untrue. Headline risk is growing concern with the increased use of Twitter and other social media, and 24/7 news coverage that create what blogger Sean McGillivray calls a “nonstop barrage of doom and gloom.”
Most investors lack the time, inclination or ability to sort through the day’s headlines to find the kernels of “actionable” information. Investors who want to minimize risks to their portfolio – including the risk of acting on faulty information – can use a strategy called diversification. A diversified portfolio contains many different types of products from different investment classes, employing a strategy that spreads risk over a large number of “baskets.” A well balanced portfolio can better weather the times the bad news bears prove right by preventing overexposure to any one investment – such as municipal bonds, for example.
Millionaire investors, known for their high financial IQs, list diversification as one of the key factors they consider when making investment decisions, according to an April survey by Spectrem Group. Diversification ranks as the top criteria for investors with $1 million to $5 million, non including primary residence. Investors with $5 million to $25 rank diversification second only to tax considerations.
An appreciation for diversification goes hand-in-hand with sensitivity to risk. While, 89 percent of the millionaires surveyed identified diversification as a key investment factor, 88 percent said they were sensitive to the risk.