On Monday, the Dow finished at a 3.5% loss, making it the third worst daily point drop in Dow history. Market commentators are blaming fears over the coronavirus as the source for the pullback.
Regardless of the reason for the drop, as an investor the question remains, how do we protect ourselves from this type of volatility? How do we insulate our life saving from the next major market correction?
At Yields4U, we firmly believe it isn't he amount of money you make, rather the amount you keep that makes the difference in retirement. Here are some of the top strategies we use to help protect our clients, these are strategies you can implement today to help reduce your downside risk in the event of another major market correction like 2008.
Strategy #1 - Have a Clear Exit Strategy!
As an investor, the last thing you want to do is to pull out of the markets at the wrong moment, at the same time you don't want to remain invested during a correction or sit on the sidelines during a recovery for too long. The only real way to protect against knee jerk investing is to have a pre-determined exit/entry strategy that matches your loss tolerance - and to stick with it.
Your exit strategy, can be as simple as when the S&P 500 falls below 12% from a recent high, or as complex as looking at macro economics. However, by using rules to dictate your actions you dramatically increase you chances for success. (see our whitepaper "How to reduce risk in volatile markets.")
Of course, you want your rules to be based on facts, for instance the 12% rule that I mentioned, wasn't a random number. Historically, major market corrections were preceded by a 12% loss in the S&P 500. There are obviously times where an investor could get whipsawed by high speed trading, however, using a simple 12% exit strategy would have allowed an investor sidestep major corrections like '87, '02, and '08.
Strategy #2 - Use Actively Managed ETFs
Actively managed ETFs, like First Trust AlphaDEX ETFs, add a layer of active selection to the indexing process. So, while your portfolio may take a hit during a recession, at least the companies you own via these active ETFs, may be ones that stand the strongest chance of making a quick recovery. Active ETFs can help you sidestep market losses, or actually help you profit from short term volatility, as always make sure to do your due diligence before buying, every ETF is managed differently, and as always past performance is no guarantee of future results.
As a bonus, look in to allocating some of your money to "contrarian" strategies. These are strategies that look for opportunities during these times of volatility and profit from "mass" hysteria. (Ask us about our low cost AI driven contrarian strategy.)
Strategy #3 - De-Risk with Investment Grade Bonds
Another way you can "de-risk" your portfolio is by allocating more of your money to "investment grade" bonds. Investment grade bonds are typically less volatile than the overall stock market. In essence you are trading the higher return of the market for greater stability of bonds.
Just a warning though, make sure you are investing in "investment grade" bonds, there are a lot of high yield or "junk" bond products out there that can carry as much, if not more, risk than equities. So make sure to do your research and pick risk appropriate funds.
Strategy #4 - Stress Test Your Portfolio
At times like this, it is always a good idea to take a second glance at your portfolio and see just how much risk you are assuming. What would happen to your savings, if we had another 10%, 20% or 40% market correct?
An easy way to stress test your portfolio, is to look at the historical returns for your top 5 or 10 holdings. Look at how they performed during the last major recessions of '02 and '08. If your holdings don't go back that far, look at August of 2015, and January to February of 2016.
Compare your portfolios losses during those periods to that of the S&P 500. Did you lose more, less or the same as the S&P 500? (Email us for a free portfolio stress test.)
Strategy #5 - Diversify Your Holdings
This goes without saying, make sure your investments aren't highly correlated to each other. For instance, if all you own are companies or sectors within the S&P 500, then when the market tanks so, will all your investments. Adding some uncorrelated international exposure, or buying investments like commodities can serve as a good hedge to market volatility.
(P.S. don't buy gold, in my opinion the only people who win with gold are those who sell it and those who were invested in it prior to the volatility starting and can benefit from the panic buying. If you'd like some hard data on the fallacy of buying gold shoot me an email and I'll send you the research.)
Strategy #6 - Check The Trading Volume For Your Portfolio
One of the hidden "gotchas" of investing is that your assets are only worth the amount that someone is willing to pay for them. Of course, on most days that amount is close to their true value.
However, on days of high volatility, where everyone is looking to sell, if you own positions that don't have high trading volume then you might find yourself taking a big haircut when you go to sell.
If you do find that you own positions with low trading volume; either resign yourself to only selling them with a "limit" order, to ensure that you get a decent price, or shift your holdings to more liquid assets that have higher trading volumes.
Strategy #7 - If Your Are Near or In Retirement Ensure You Have Adequate Cash
One of the greatest risk during retirement is Sequence Risk, or the risk of being forced to liquidate positions while they are at a loss, thus compounding your market losses and increasing your time to recovery.
There are two easy ways to solve for this problem, one solution is to shift more of your assets to cash. Of course, you don't really want to hold cash, but something like SHY or AGG which will get you a nominal return for your money without carrying much risk.
You may also want to consider a risk allocation or a time banding approach to investing, with risk allocation, accounts that are used to pay for immediate expenses are invested in lower volatility strategies than those that are earmarked for later years in retirement. This allows long term assets to remain invested while protecting immediate and short term needs from the roller coaster ride of the markets.
Strategy #8 - Consider Structured Products
Structured products are essentially custom forward or future contracts that allow you to swap the upside of the market for a predetermined protection. This protection can be in the form of a contractual limit on losses or a trade of one loss for another.
Structured products are similar to market linked bank CDs that some investors may be familiar with, but with significantly more options. When used properly these investments can help mitigate your downside potential while allowing you to benefit from market gains.
If you have any questions, or if you would like help implementing any of these strategies in your portfolio, don't hesitate to ask.