4 strategies to protect your portfolio from strong market downturns
By Riley Cooper, guest contributor
–The recent stock market meltdown seen during February and March has left investors a bit discomforted amid the possibility of seeing the value of their holdings evaporate in a matter of weeks when markets face unforeseen circumstances like the pandemic.
Although this is not the first time that such a strong downturn in market valuations occur, it is definitely a warning signal that has led to some cautiousness among the most conservative investors in regards to how they can hedge against these black swan events.
Although nobody can really predict what is going to happen in the future and how those events will affect the financial markets, there are certain ways in which investors can limit the amount of losses they take.
The systematic combination of these tools is known as a portfolio’s risk management strategy and the following article aims to describe four of them so you can explore the basics of this practice.
Hedging against strong downturns is not a perfect science
One of the first few things you should know about risk management is that it is impossible to protect your portfolio from all unfavorable scenarios while it would also be very expensive to do so.
Most of the risk management strategies that will be explained in this article involve the purchase of a financial security – at a cost – or using a tool that limits your losses at the risk of possibly missing out on some potential future profits.
Hence, there’s no perfect risk management strategy that guarantees 100% protection without a downside.
Strategy #1 – Using stop-loss orders
Stop-loss orders were designed to trigger a market order once the price of a security has reached a certain level – also known as the stop price.
These orders are often placed after the security is purchased and they can limit the amount of losses your portfolio will experience if the market goes down sharply.
Downside: From a long-term perspective, a huge downward swing can end up taking you out of a long position, leaving you with a realized loss that might have been turned into a profit if you kept the security for longer instead of selling.
Strategy #2 – Using put options
Put options are a derivative instrument that gives you the right – not the obligation – of selling a certain security at a given price once the contract expires.
These instruments can be bought to secure an exit price for your position in case the market goes down. You will either be able to sell your entire stake at that price point or you could sell the put options at a higher premium before they expire.
Downside: you have to pay a premium to buy these options and, similarly to purchasing an insurance policy, you will end up losing this premium if the market doesn’t go down before the expiration date.
Strategy #3 – Using technical signals
Experienced traders use charts and indicators to determine if a certain uptrend is about to reverse.
Their analysis often seeks to identify potential sell signals to exit a position before it turns against them. This helps them in either securing their profits or limiting their losses.
Some of these signals include support breaks, trend line breaks, and overbought signals, among others.
Downside: this is a sophisticated strategy that you should only use after learning the intricacies of technical analysis. Additionally, there are no infallible signals and faulty technical analysis can lead to wrong conclusions.
Strategy #4 – Using negatively correlated securities
A security’s correlation indicates how similarly the performance of a certain financial instrument behaves in relation to another – or, in this case, to your entire portfolio.
Certain tools like Portfolio Visualizer allows you to check the correlation between the instruments contained within your portfolio as a way to determine how they will perform relative to each other.
A correlation – positive or negative – going from 0.7 to 1 is typically considered strong. Meanwhile, a negative correlation means that the two instruments move in opposite directions – that is, when one goes down the other goes up and vice versa.
As a risk management strategy, investors can purchase a certain amount in negatively correlated assets, which will produce gains in case the broad portfolio goes down. This would effectively limit the losses experienced by the portfolio in case of a strong downturn.
Downside: when your overall portfolio is doing good, these securities will cap your profits to some extent as their value will decline at the same time.
Although no risk management system can fully protect you from losing money if markets suddenly nosedive, these strategies can help you offset some of those losses. However, that protection, as you have learned, comes at a cost.