Stock market volatility is a fact of investing, especially in the short-term. While stock market returns tend to smooth out over time, trending higher overall, it can still be upsetting when youâ€™re watching your portfolio performance during a stock market event or during times when there are wide swings in performance.
In times of volatility, many investors start looking for portfolio protection. If youâ€™re worried about whatâ€™s next, here are seven strategies you can follow to help you weather the next storm.
â€śThe first thing to do if you want to protect your portfolio is stop watching financial news,â€ť says Roger Wohlner, a financial advisor, MagnifyMoney contributor and founder of the blog The Chicago Financial Planner. â€śItâ€™s easy to get wound up and make decisions based on the stock market, and not based on your risk tolerance and portfolio needs.â€ť
Wohlner points out that recessions and market downturns are regular parts of the economic cycle, and that itâ€™s better to stick with your plan than to change everything the moment the news gets bad.
â€śYouâ€™ll probably need to make tweaks as you go along,â€ť Wohlner acknowledges, â€śbut you should make those changes because youâ€™ve considered your plan, your needs, and the fundamentals of your portfolio, not because someone is yelling about it on TV.â€ť
Diversification can be another way to engage in portfolio protection. One of the main tenets of Modern Portfolio Theory, the Nobel-winning theory introduced by Harry Markowitz, is that the asset class makeup of your portfolio matters more than the individual securities you choose.
With diversification, you protect your portfolio in the event that one particular portion of the market is hit hard. It limits the damage done when one asset class plummets, or if a particular sector underperforms.
In order to diversify your portfolio, itâ€™s important to consider the following factors:
â€śAppropriate diversification can help you weather market downturns,â€ť says Wohlner. â€śMake sure youâ€™re not relying on a few individual stocks, or that you are too heavily invested in a particular industry.â€ť
While the stock market offers ample opportunities for growth, the reality is that systemic risk is a real concern. There are times when the whole market drops, and portfolio protection is difficult in those circumstances.
Adding assets that donâ€™t correlate with the stock market can be a way to introduce a measure of portfolio protection. Some assets that donâ€™t necessarily move the same way as stocks include:
Additionally, cryptocurrencies are increasingly being seen as an asset class, and some investors like to use peer-to-peer loans as a way to introduce non-correlating assets to their portfolios.
Wohlner warns against relying too heavily on non-correlating assets, though. â€śYour best bet is still a portfolio constructed mainly of stocks and bonds,â€ť he says. â€śBut if you want to take a small portion of your portfolio and use it for other assets, that can be one way to reduce your risk.â€ť
Wohlner is an advocate of using a bucket strategy to avoid the issues that come with a steep stock market drop. With the bucket strategy, you construct your overall portfolio based around when you need access to your money.
Money you think youâ€™ll need within three to five years should be kept in cash and cash-like securities.
â€śWhen you plan it this way, you shift assets before market problems, and you have access to the cash you need without having to liquidate stocks when theyâ€™re down,â€ť says Wohlner.
Other buckets include a medium-term bucket with dividend-paying stocks and other dividend-related investments, and a long-term bucket comprised mostly of money you wonâ€™t need for more than 10 years that is invested mainly in stocks.
A bucket strategy can be used as a rebalancing tactic to help keep your portfolio in line with your goals and needs, no matter what the markets are doing, Wohlner points out.
Dividend-paying investments can contribute to portfolio protection by adding to a securityâ€™s overall return, as well as providing an additional hedge against inflation.
Some investors like to use dividend aristocrats, says Wohlner, because they are companies that have increased their dividends every year for at least 25 years. Additionally, real estate investment trusts are known for their dividends and their ability to add exposure to another asset class in your portfolio.
Related to dividend investments is the ability to invest in businesses or start businesses to receive another revenue stream. â€śAnytime you can find additional types of revenue, you can protect your portfolio and your finances better, no matter the economic situation,â€ť says Wohlner.
Itâ€™s also possible to look for assets that offer portfolio protection in specific ways. You can add assets that guarantee your principal as well as securities designed specifically to combat inflation.
While these types of assets can provide you with peace of mind, they might not allow you to grow your wealth like you need to. â€śThereâ€™s nothing wrong with having a portion of your portfolio in these assets,â€ť says Wohlner. â€śBut you canâ€™t rely on them completely to provide the portfolio growth you need.â€ť
Advanced investors sometimes use various options strategies for portfolio protection. While there are many different types of options, put options are popular because they allow investors the right to sell a stock at a certain price within a set amount of time. If a stock drops, profits from selling the option can offset the drop in price.
There are other options strategies that can be employed to protect unrealized profits and offset portfolio losses. However, these strategies themselves can be risky and Wohlner warns against becoming too reliant on options as a strategy to protect your portfolio.
For most investors, the best way to protect a portfolio is to come up with a plan that helps them achieve their goals and then stick with it, rather than selling stocks in response to a perceived crisis, according to Wohlner.
â€śYou can rebalance as needed and change the plan as circumstances require, but most investors are better off preparing for inevitable downturns ahead of time with a good long-term portfolio strategy,â€ť he says. â€śAnytime youâ€™re making changes just because the market is doing something that scares you, chances are things will work out poorly for you.â€ť