- An investment portfolio designed to help reduce value lost in a market decline has less ground to make up in a subsequent recovery.
- A loss mitigation strategy can help you manage the risk of declines and avoid the urge for unplanned selling in your portfolio over time.
- One of the most effective and widely practiced downside risk strategies is asset diversification.
The U.S. and global economies continue to recover from their second quarter slowdown. But the recovery remains uneven as COVID-19 remains a headwind against business activity.
While corporate profits have suffered, stock markets around the globe have risen in response to massive amounts of fiscal and monetary stimulus. However, we believe the recovery will continue — as earnings improve, stock prices can rise modestly, over time.
With this environment, now may be an opportune time to talk with your advisor and revisit one of the primary risk-management tools for a long-term portfolio: a downside risk strategy.
The principle behind a downside risk strategy is a portfolio that loses less of its value in a market decline has less ground to make up in a subsequent recovery. The goal of this approach is to position the portfolio to recover more quickly — and with a higher portfolio value to benefit more fully as asset prices rise.
Simple arithmetic illustrates the value of the concept:
- If a $100,000 portfolio suffers a market decline of 25%, its value would fall to $75,000.
- However, regaining the lost $25,000 now requires the portfolio to rise by 33%.1
- A recovery of that magnitude can be doable in the right conditions but is still a tall order.
But what if we applied risk-mitigation strategies to the same $100,000 portfolio, and it suffered an initial decline of just 15% to $85,000?
- To get back to even, it would need to gain approximately 18%, far less than the 33% required in the first example.1
- The more quickly the portfolio recovers, the sooner it can begin to grow in value again.
- Stemming losses can also help reduce the urge to panic sell during a market downturn.
- Remaining invested enables the portfolio to participate in the eventual market recovery.
Strategies to limit risk in investment portfolios
One of the most effective and widely practiced downside risk strategies is asset diversification. The old adage of not putting all of one’s eggs in one basket applies.
Asset categories such as stocks, bonds, cash and alternative investments may react differently from one another during a downturn. By combining them, investors may lower their portfolio volatility and reduce the extent of losses.
Here are additional strategies that can help reduce downside risk:
- Exposure to historically defensive sectors of the equity market, such as Consumer Staples, Utilities and Real Estate.
- The use of factor investing. With specialized investment vehicles, it is possible to target specific factors or attributes of certain asset categories. Examples include:
- Funds that invest in historically low-volatility stocks (relative to price)
- High dividend-paying stocks and stocks with a history of growing their dividends
- Stocks of companies with strong balance sheets and high-quality earnings
- Options and structured product strategies
In the fixed-income universe, the prevailing low-yield environment has led many investors to “reach for yield” by investing in lower-rated, less liquid bonds. While that strategy was rewarded during the record U.S. economic expansion, it was punished during the springtime recession. Credit quality deteriorated, defaults increased, and bond prices fell.
Bond prices have recovered as the economy has improved further since the second quarter, but we continue to believe it’s prudent to focus on asset quality and liquidity in fixed income. Consider emphasizing investment-grade corporate and government bonds. Be selective within high-yield bonds.
As with any investment strategy, not overpaying is critically important. Downside risk strategies are widely employed in the current environment. Such strategies can cause some investments to become overvalued relative to their longer-term history. It pays to do your homework.
If you would like to learn more about these and other risk-mitigation strategies, please contact your Ameriprise financial advisor. They know your financial goals and investments best and can help determine whether these strategies may be appropriate for you.
1 The illustration is hypothetical and is not meant to represent any specific investment or imply any guaranteed rate of return. Client experiences will vary.