Worst-Case Scenario

By Daniel Kadlec

Federal marshals are guarding overseas flights, and state troopers are patrolling trains. What makes you think your portfolio couldn't use some extra security too? Renewed terrorism concerns, punctuated by the Madrid bombings on 3/11, pushed the Dow to its first drop of more than 5% in a year. Still, prevailing wisdom holds that investors should do nothing. Terrorism strikes are unpredictable, the reasoning goes, so you can't invest around them.

Nonsense. Some $100 billion will be spent on homeland security over the next few years with or without any domestic terrorism, and that provides a rich backdrop for certain defense and technology stocks. Meanwhile, gold and oil are a great hedge against geopolitical turmoil and should do fine anyway, as fast-growing China inhales the world's natural resources. Holding extra cash is a buffer against the unknown and could pay double if you invest it in the teeth of a terrorism sell-off and then wait for the inevitable rebound.

If this all sounds a bit cold, remember: money has no emotions, and presumably you would still like to retire one day. Building terrorism protection into your portfolio isn't unpatriotic. Ask Jeffrey Immelt, CEO of General Electric, who in March inked a deal to take over InVision Technologies, a bomb-detection company. GE paid dearly: $50 a share, or 33 times expected earnings and double the price of a year ago. You think Immelt isn't buying protection for GE? The greater the threat, the better the business for InVision.

How should you approach this gut-wrenching issue? Do nothing drastic. The economy will sink or swim on its own merits. Far too much is made of the recession post--Sept. 11, 2001. It had begun long before the attacks and, arguably, ended more quickly because of them. Yet a few adjustments can smooth any terrorism-related market bumps and raise the odds that you will stay invested long term. "Think through the scenarios," says David Darst, chief strategist at Morgan Stanley Individual Investor Group. "People do themselves a disservice to ignore the threat." How to protect your portfolio:

PUMP UP CASH Instead of holding 5% to 10% in a money-market fund, hold 10% to 15%. The cushion will trim returns in normal times, but soften any declines and give you means to buy on a terrorism-related dip. The Dow rebounded 4% after the Madrid sell-off. That's a fairly normal pattern, according to Markethistory.com

IDENTIFY LIKELY WINNERS Gold stocks (Barrick, Newmont) and oil services and drillers (Anadarko, Schlumberger) tend to rise amid global turmoil. They also benefit from the kind of global expansion we're now seeing (led by China). Traditional safe-haven stocks like drugs (Pfizer, Merck), tobacco (Altria) and beverages (Anheuser-Busch) would hold up relatively well, and may come into favor anyway because they pay decent dividends.

IDENTIFY LIKELY LOSERS Easy does it. But lighten up on anything that is travel related (airlines, hotels, leisure) or that relies on discretionary spending (autos, retail).

PLAY DEFENSE As the GE purchase of InVision shows, small-and mid-size security firms are hot bait. They will benefit from both rising government spending and being takeover targets. Among them: Armor Holdings, Verint Systems, OSI Systems and Ceradyne.

BORDER PATROL Muni bonds are a safe haven, but a single event could crush all bonds in a region. So diversify geographically. And avoid bonds backed by revenue of potential targets, like power plants. It's no fun to think this way. But it's prudent.