By Brian Spinelli, CFP®, AIF®, Co-Chief Investment Officer
In today’s fast-paced and uncertain financial landscape, investors need to be strategic and smart about developing a portfolio strategy that protects them from significant downside. With financial markets becoming increasingly volatile, keeping your wealth intact—or even growing it—can be challenging. That’s why it’s important to evaluate and consider new ways and techniques of diversifying assets and implementing effective risk management strategies.
Below, we will explore various downside protection techniques that can help safeguard your investments against market downturns.
What Is Downside Protection?
Portfolio downside protection is a critical concept in the world of investing, as it is designed to help mitigate potential losses that may arise when market conditions are unfavorable. This vital risk management strategy involves incorporating diverse investment tools and techniques into a portfolio to navigate uncertainties and limit the damaging effects on one’s wealth. The primary aim of downside protection is to preserve the investor’s initial capital and guard against market downturns by employing various tactics such as diversification, asset allocation, and the use of alternative investments beyond publicly traded stocks and bonds. Crafted with an understanding of the investor’s unique risk tolerance and financial goals, a well-executed downside protection plan can ensure a sense of financial stability in unpredictable markets while optimizing returns in the long run.
Diversification: A Time-Tested Strategy
Diversification is a cornerstone of investing, and for good reason: it helps spread your risk across multiple assets, reducing the impact of a single poor-performing investment on your overall portfolio. To diversify effectively, consider investing in a mix of asset classes, sectors, and geographies. This might include stocks, bonds, real estate, and even alternative investments including private markets. By spreading your investments across a wide range of assets, you can better protect your portfolio against market downturns and lessen the impact of any single market event.
Asset Allocation: Balancing Risk and Reward
Asset allocation is another crucial aspect of downside protection. This involves dividing your investments among different asset classes based on your risk tolerance, investment goals, and time horizon. Generally, more conservative investors may opt for a higher allocation of bonds and cash, while more aggressive investors might lean towards stocks and other higher-risk assets. The key is to find a balance that matches your risk appetite and time horizon while still providing opportunities for growth. Solely focusing on downside protection in a long-term portfolio (5 year horizon or more) should come with proper return expectations. Investing in higher volatility investments, such as basket of publicly traded stocks, come with higher return expectations to compensate investors for bearing short term risk. Investing more conservatively should come with lower return expectations than a more aggressive allocation over the long-term. Historically, the longer an investor can bear volatility, the better their returns historically have been. Using history as a guide, stocks usually outperform bonds which should outperform cash.
Alternative Investments: A Buffer Against Stock Market Turbulence
During periods of public market volatility, alternative investments can offer a measure of stability to your portfolio. These are strategies that can invest in public and private markets. In public markets, this could include trend following strategies intended to reduce volatility when momentum in public markets is declining. For example, reducing the amount allocated to stocks and increasing allocations to more stable assets such as cash and/or bonds. These types of strategies can involve rules-based decisions designed to avoid trading on emotion and sentiment. Other types of strategies can involve active money managers making decisions to hedge based on current market conditions or outlooks. In private markets this could include physical real estate, private equity and private credit (lending). These areas have historically not moved in lock step with publicly traded stocks and bonds and have helped portfolios dampen the effects of short-term reactions from daily traded markets. While private markets don’t fluctuate as quickly as daily liquid markets, they are not immune to declines and risk of losing money. At a very high level they do not price daily nor respond to minute-by-minute moves during market trading hours. They are typically accessing areas of the capital markets not available in traditional stock and bond markets thereby allowing additional diversification in portfolios.
Fixed-Income Investments: A Cushion for Your Portfolio
Bonds and other fixed-income investments can also provide downside protection in turbulent times. These investments pay regular interest income and typically have lower volatility than stocks, making them an attractive option for conservative investors. High-quality bonds, such as government or corporate bonds with strong credit ratings, can be particularly helpful in mitigating risk during market downturns. However, keep in mind that interest rate changes can affect bond prices, so it’s important to monitor your fixed-income investments and adjust your strategy as needed.
Hedging Strategies: Insuring Against Losses
Hedging is a more advanced risk management technique that involves using financial instruments like options or futures to offset potential losses in your portfolio. For example, an investor who owns stocks might purchase put options, which give them the right to sell those stocks at a predetermined price within a specified timeframe. If the stock price drops, the put option increases in value, offsetting the loss in the underlying stock. Think of puts or hedges as an insurance mechanism. You pay a cost (aka a premium) for insurance and if the loss event does not occur your premiums do not get returned to you. This is compensating the other party in the trade for taking on the risk you are trying to mitigate. A study by BlackRock found that investors who used hedging strategies during the 2008 financial crisis outperformed those who did not, highlighting the potential benefits of using more advanced risk management techniques. However, hedging strategies can be complex and may not be suitable for all investors. It’s essential to understand the risks and costs involved and work with a financial advisor if you’re considering using these tools.
Cash Reserves: A Safety Net for Unpredictable Times
Maintaining a cash reserve is another way to protect your portfolio from downside risk. In the event of a market downturn, cash can serve as a buffer, giving you the flexibility to ride out the storm without having to sell assets at a loss. Additionally, cash reserves can provide you with the opportunity to take advantage of market dislocations, allowing you to purchase undervalued assets during a downturn. Additionally, having cash reserves as part of your overall strategy is helpful when unexpected costs arise year to year. This provides an area to pull money from when other portfolio assets may be down avoiding having to sell assets in those periods.
The Bottom Line
Safeguarding your portfolio against significant market downturns is crucial in today’s volatile financial landscape. By employing a range of strategies—such as diversification, asset allocation, alternatives and fixed-income investments, hedging, and maintaining cash reserves—you can better protect your wealth and navigate market turbulence with confidence. As every investor’s situation is unique, it is essential to evaluate and tailor these strategies to your specific risk tolerance, investment goals, and time horizon. Remember, a well-rounded and resilient portfolio is key to achieving long-term financial success, and downside protection plays a vital role in building that foundation. Start implementing downside protection techniques today to safeguard your wealth and achieve long-term financial success. Talk to an advisor at Halbert Hargrove to learn more about how you can tailor these strategies to your unique situation and goals.
Disclaimer:
Halbert Hargrove Global Advisors, LLC (“HH”) is an SEC registered investment adviser located in Long Beach, California. Registration does not imply a certain level of skill or training. Additional information about HH, including our registration status, fees, and services can be found at www.halberthargrove.com. This blog is provided for informational purposes only and should not be construed as personalized investment advice. It should not be construed as a solicitation to offer personal securities transactions or provide personalized investment advice. The information provided does not constitute any legal, tax or accounting advice. We recommend that you seek the advice of a qualified attorney and accountant.
