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Staying invested is easier if you know how your portfolio will react to a falling market.
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Diversification is a powerful tool that can protect you from fickle times.
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Alternative investments can be important when stock and bonds are shaky.
Everyone knows that the stock market is volatile by its very nature. Yet many people tend to go on a panic-induced selling frenzy whenever there is a sharp dip in the market.
Panic decisions are, naturally, a bad idea. It can prevent you from achieving your financial goals and impede long-term wealth creation.
Below is a list of tried-and-tested strategies that can protect your portfolio from short-term volatilities and minimize your losses in the event of a downturn.
Portfolio diversification
Ask any investment expert and they will tell you that a diversified portfolio tends to outperform a concentrated portfolio in the long term. In most cases, a market downturn does not affect all the asset classes equally.
When some assets plummet in value others can perform well. By diversifying your investments, you can make sure that the losses you suffer are offset by the profits you make.
According to the Modern Portfolio Theory (MPT), the asset classes you choose to invest in are more important than the individual securities in which you invest.
A truly diversified portfolio should include the following components.
- Different types of assets (stocks, bonds, commodities, real estate, and so on)
- Different industries and sectors (utilities, technology, retail, and so on)
- Global exposure (U.S. based assets as well as non-U.S. based assets)
- Mutual funds and ETFs
- Different approaches to investing (growth, value, and income stocks, large, mid, and small cap stocks, and so on)
By diversifying your investment portfolio you can minimize your losses to a great extent in the event of a downturn and maximize the earning potential at the same time.
Non-correlating assets
While diversification can protect you from non-systemic risks (risks associated with a specific company, industry, or sector), it cannot protect you from systemic risks (risks associated with investing in the market).
This is why even diversified portfolios tend to lose value in the event of a major downturn or crash.
You can, however, protect your portfolio from systematic risks by investing in assets that do not correlate with the market.
The most common examples of non-correlating assets are real estate (investing in a physical property), commodities, foreign currencies, and bonds.
Cryptocurrencies also have emerged as an asset class and their growth is usually not tied to the performance of the market.
You should, however, be cautious in your approach as the crypto industry is still in its infancy and is prone to wild swings, as witnessed in the case of Bitcoin.
Alternative investments
This is an extension of the previous point, as alternative investments are considered non-correlating assets as well.
These are investments whose value and growth rate are not usually dependent on market conditions. By adding them to your portfolio, you can reduce your vulnerability to systematic risks to a great extent.
The most common types of alternative investments include:
- Private equity (investing in private companies)
- Venture capital (investing in startups with great potential)
- Real assets (investing in physical assets like agricultural land, residential and commercial properties, and precious metals)
- Collectibles (investing in collectible items like antique furniture, jewelry, rare coins, stamps, wine, fine art, sports and film related memorabilia, and so on)
- Hedge funds (investing in pooled investment funds that undertake high risk strategies for higher returns)
- Peer-to-peer lending (investing in peer-to-peer lending platforms which offer loans to those who do not qualify for bank loans)
Dividend paying investments
Investing in stocks and funds that pay dividends on a regular basis is one of the best ways to protect your investment portfolio from short term volatilities.
The dividends paid by the companies serve as an additional income stream, provide some much-needed cushion when stock prices decline, and increase your portfolio’s overall returns in the long run.
Principal protected and inflation protected investments
Principal protected investments, as the name indicates, protect your principal from market volatility.
For example, principal protected notes guarantee a rate of return which is equivalent to the principal you invest. In addition to this, a small portion of your principal is also invested in the market.
If the asset classes in which your money is invested perform well, you will be paid the principal amount as well as a portion of the profits. If they do not, you will be paid the principal amount alone.
Inflation protected investments, on the other hand, are investments whose rate of return is adjusted based on the rate of inflation.
For example, Treasury inflation protected securities (TIPS) guarantee a rate of return which is periodically adjusted based on the inflation rate.
Principal protected and inflation protected investments can be a good addition to your portfolio, particularly if you are worried about losing your principal due to unfavorable market conditions or high inflation.
At the same time, you should remember that these investments are only meant to provide your portfolio with a sense of balance and stability. For long-term wealth creation, stocks and bonds are your best bet.
Dollar cost averaging
This is a time-tested strategy to safeguard your portfolio from market volatilities. Dollar cost averaging is a method in which you invest a specific amount of money on a regular basis.
When stock prices are high, your investment will purchase a small amount of stocks.
When they are on a decline the same dollars buy a large amount of stocks. The point is to keep purchasing stocks at regular intervals irrespective of their price.
By doing so, you can take full advantage of the market’s growth in the long term.
Avoid daily market updates
There are a number of news channels, online channels, and mobile apps that provide you with stock market updates on a regular basis.
While it is good to have such reliable sources of information at your disposal, you do not have to follow them on an hourly basis.
If you are focused on long-term wealth creation, there is no reason why you should bother yourself with short-term fluctuations.
Stay invested, reap the rewards
Remember, the market rewards the committed investor. Rather than worrying about timing the market, focus on building a diversified portfolio which is protected against systematic as well as unsystematic risks, using the aforementioned strategies.
It will definitely pay well in the long run.
