Is Your Portfolio Protected in the Case of a Downturn? Here’s How to Know for Sure

January 3, 2022

It’s nearly impossible to predict a downturn but there are some ways to be prepared. Whether it’s a short-term stock market selloff or a full-on downturn, portfolio managers have many tools at their fingertips to ensure that investments are protected.

Investors can inquire with their portfolio managers and pour through fund brochures to understand what is being done to protect their investments on the downside. Investors managing their own portfolios can often put the same strategies in place themselves.

Here are some questions to find out how well your portfolio is protected in case of a downturn.

Is your portfolio diversified enough?

Diversification can prevent maximizing returns but it also offers protection. More specifically, some exposure to European or other non-U.S. stocks can keep a portfolio afloat in case of a downturn in the U.S. economy. Diversification using value stocks, investment-grade corporate bonds and foreign bonds can also be beneficial if something goes wrong.

Do you have enough cash in your portfolio?

It’s sometimes a good idea to keep a portion of your portfolio in cash. That cash won’t be at risk of losing value, and can act as an emergency fund. Managers typically suggest keeping at the very least 5% of a portfolio in cash, and up to 10% or 20% for the most risk averse investors. Also note that this cash should be set aside before any downturn occurs, and in a best-case scenario could be used to purchase quality stocks at rock-bottom prices during a downturn.

Does your portfolio hold assets that aren’t correlated with the stock market and other risky assets?

Investing in different asset classes with low correlation can help reduce volatility and soften the blow of losses in some parts of a portfolio. Non-correlated assets include currencies, commodities, emerging market bonds. Alternative assets including private infrastructure and investments in art, collectibles, and wine are also non-correlated assets that don’t move in tandem with stock market fluctuations in the event of a downturn.

Does your portfolio hold dividend-paying stocks?

Dividend paying stocks act like fixed income as they provide a stream of passive and predictable income to shareholders, which is why they are often recommended for investors nearing retirement and in need of a more conservative portfolio. Even though dividend yields are paid out of cash flow, which can dwindle in a downturn, they are historically less volatile than stock prices.

Do you use options in your portfolio?

Options are great tools to reduce risk in a downturn but they can be intimidating to some investors because of their inherent complexity. Buying put options can work as an insurance on a stock portfolio against a loss when stock prices fall. With a put option, an investor can sell a stock at a specific price within a given timeframe. If a stock goes up, the investor doesn’t need to exercise the put option and only loses the fee spent to book the put option. But if the price of the stock goes down, the investor can limit the losses by having decided ahead of time at what level he or she wants to sell the share.

Are stop losses part of your strategy?

A stop order sets a specific price at which the investor wants to sell. If the stock drops, the stop triggers a market order, allowing the investor to minimize losses. Although it acts like a brake in theory, it has certain limitations in practice. The main problem is that in a fast-moving market, there’s not always a guarantee that the stock will find a buyer at the designated price. Although the stop order will be able to minimize losses, it may not do so at the exact level initially anticipated.

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