With the current bull market having extended beyond eight years, and with stock market indexes reaching all-time highs, many investors have become nervous: What might happen to their portfolios if there is a big market pullback?
At this stage of the market cycle, valuations can begin to look stretched, which has investors thinking about their best options should a market correction occur.
To be sure, market corrections are common. However, it’s the prospect of a double-digit market pullback that is worrisome for investors. After all, intra-year declines have averaged 16.8 percent over the last 10 years, despite the stock market being mostly positive.
The potential for a significant market decline presents a dilemma for today’s investor: Continue with similar levels of exposure to the equity market and assume the risk? Or swap the equity risk for the interest-rate risk that comes with an allocation to fixed income?
One possible solution to protect a portfolio from downside risk is the use of options and other hedging instruments that might limit or reduce losses in the event of a decline in the value of the underlying security. In addition to hedging strategies, there are a host of other solutions that are uncorrelated to the stock market that might limit investors’ losses in the event of a significant market pullback.
We at KAR have extensive experience with assets that have little or no correlation to the general stock market, helping our clients add diversification to their portfolios, while shielding their portfolios’ value from downside risk. Here are several strategies that may be worth considering.
Options strategies on equity indexes can be a cost-effective way for investors to add downside protection to their portfolios. One example is a put option, which allows an investor to benefit from a decrease in the price of the underlying asset, while also limiting the amount of loss the investor may sustain. When the price of a security falls below a predetermined price, investors can avoid additional losses by exercising those options and selling their shares.
Another common strategy used to manage downside risk is to purchase assets that deliver most of their investment return as income, as those assets typically have lower sensitivity to market changes. This may be accomplished using high-dividend-paying stocks, or by adding certain securities to a portfolio, such as real estate or REITs, which may provide solid income return relative to capital appreciation.
Insurance-linked securities (ILS) are financial instruments whose value is affected by an insured loss event. ILS can include catastrophe bonds and other forms of risk-linked securities. ILS have low correlation to the broader market and have performed better during periods of financial crisis and instability.
An actively managed strategy, such as a market-neutral one, may help investors manage downside risk, as the investments are not correlated to the market. In a market-neutral strategy, an investment manager seeks to profit from fluctuating prices while attempting to avoid several macroeconomic factors. Due to its lack of correlation with the broad markets, in the long run, a portfolio incorporating a market-neutral strategy can add diversification and protect itself from the risks of traditional stock and bonds.
As with any investment, there are risks associated with the above-mentioned solutions. It may be prudent to talk with your financial advisor or investment manager about the steps they take to manage such risks.
As stock valuations get pushed higher, and with today’s growing volatility, investors may want to consider options to protect their capital. That’s why we believe it’s important to position your portfolio to take advantage of the market’s upside, while shielding it from an inevitable pullback.