As a growing number of global issues cause concern for investors, caution has started to wash over financial markets. A number of fund managers are bracing for the fallout in relation to debt concerns associated with Chinese property developer Evergrande, geopolitical tension is on the rise, while the Federal Reserve is also tipped to begin tapering its bond-buying activity in the coming months.
While none of these events may necessarily trigger a market downturn, as is often the case with events that raise uncertainty, downside risk and volatility are something that investors should always have a strategy to deal with. Earlier this week, the S&P/ASX 200 VIX index, a measure of implied volatility across the market defining expectations for near-term volatility, was up nearly 40% in the last fortnight, trading at levels last seen in May.
With the above in mind, and some investors wondering whether a market downturn might be on the cards after a record streak for markets, how do investors typically manage downside risk?
Hedging positions and diversifying
Hedging is a form of risk management designed to mitigate and protect the value of a portfolio from unforeseen events. One asset is used to offset movement in the value of another asset, avoiding the need to try ‘time’ or ‘predict’ market movements.
When it comes to shares, this strategy offers exposure to price movements that might oppose the core positions in a portfolio and thus reduces downside risk. In some cases, investors use options and other financial instruments to hedge, albeit these products are typically quite complex for the new investor. Inverse ETFs, including those with leverage, have emerged in recent times, which provide direct exposure to bet against the market and profit as stock prices fall. While these ETFs have at times been marketed as a short-term trading hedge, they come with significant risk and should only be considered by experienced investors.
On the other hand, diversification is a simpler tool for dealing with downside risk, albeit in a different manner. Diversification should not be mistaken for hedging as it concerns smoothing out risk across a portfolio, whereas the latter is a tool used to mitigate portfolio losses that may arise from certain positions.
Nonetheless, by taking up stocks in different sectors or industries, you are mitigating some of your risk. Whereas high-growth businesses, including tech and battery metals names, are among the most-likely to see volatility during a market downturn, there is some ‘defensiveness’ in other areas of the economy, including consumer staples, telecoms and infrastructure.
What’s more, an investor may consider geographic diversification by spreading their exposure to equities over different stock markets. That might include a portfolio made up of both ASX and US stocks, which are leveraged to different trends and thematics.
ETFs are viewed as a popular choice for investors to consider diversifying and reducing their risk exposure, as they mitigate the loss in any one position within a portfolio. This is because ETFs track a basket of stocks, typically indexes or sectors.
Should investors sell at the first sign of a market downturn?
When volatility first hits markets, investors are sometimes of the mindset that it is easier to sell first, ask questions later. And while this may help an investor take their profits or mitigate their losses, there is also the prospect that things don’t play out as expected – not to mention, the tax implications that come with it. Even then, the ‘first sign’ of a market downturn often doesn’t emerge clearly, let alone at the same time for every investor.
There is also considerable difficulty, and in some instances, sheer luck required to time an exit when it comes to selling shares before a market downturn, as well as trying to buy stocks at the bottom of a market downturn. Statistically, few will get this right across the course of their investment journey, so you can imagine the difficulty when this relates to the middle of a volatile period.
Although it can seem like a daunting prospect when volatility starts to take hold and profits disappear, on paper at least, holding quality stocks and ETFs has proven to be one of the most-effective investment strategies over the long-run when looking at sustainable returns.
If we look to most major market corrections, the stock market has typically recovered ground over time and gone on to trend higher, and along with returns provided from the likes of dividends and corporate action, it has often proven to be a case where it is better to spend time in the market rather than trying to time the market.
In fact, when looking at performance data between 1930 and 2020, if investors sat out the S&P 500’s best ten days of each decade, which are typically in the midst of the most volatile periods where there have been downturns, total returns would be just 91% compared with nearly 15,000%. This may suggest that even if you are exposed to a slump in the market, the upswing is what can have a profound impact on your portfolio. Just think back to last year, amid the start of the pandemic. Many of those who kept the faith benefitted as stocks surged to a series of new all-time highs.
On top of this, a number of companies have the ability to perform well in any environment, even as a market downturn ensues. The key is being able to identify resilient businesses that are equipped to deal with the broader macroeconomic environment and outperform, or where the inherent fundamentals and newsflow of a company paints a bright outlook.
Dollar cost averaging
Another investment strategy favoured in ‘normal’ times, let alone seeks to take advantage of prolonged market volatility, is dollar cost averaging. This is where one invests a consistent amount of money into a stock at regular intervals.
In a falling market, dollar cost averaging may help one lower their cost average and reduce the risk associated with when one buys shares. This strategy has the most upside when it is anticipated that a stock’s performance has been temporarily impacted by something outside its control, but where its long-term prospects remain sound.
Although a dollar cost averaging strategy offers potentially high reward, you also need to take into consideration what the other side of the equation might be. Not only is there some opportunity cost involved by committing to existing holdings, rather than identifying other stocks that might be opportune long-term investment opportunities, but if the market continues to fall, then losses may compound, at least in the short term.
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