Downside Protection

What is Protection from Downside Risk?

You might get nervous whenever the S&P 500 or other major indexes slip a little if you’re investing to build wealth—and especially if you’re in or near retirement. So what can you do to protect your portfolio and help you better manage your risk?

Something that all hedge funds, venture capital firms, and institutional investors do, employ some strategies that protect against downside risk. But what is the downside meaning?

Simply put, the downside means the overall market, not just one or two sectors, experience a massive selloff. Investors use downside protection strategies to protect against losses. These strategies can help protect their money invested in the market, even when stocks plunge.

For many long-term investors with mutual funds and ETFs that are already diversified, the day-to-day fluctuations of the markets are less important than the long-term gains they expect to see. However, even during the most bullish market, prudent investors are always prepared for the inevitable bear market, no matter which downside protection strategy they follow.

Some downside risk protection strategies are sophisticated, best suited for those who are experienced or professional investors, like venture capital firms or those institutional investors. Some of these strategies include stop-losses and trailing stops, which you can set in order to make sure some of your largest positions don't lose more value than you are comfortable with. Others use options contracts like call and put options as a way to hedge their portfolio.

Others are simpler to adopt for the average or starting investor. For example, you could research and buy investments that tend to do well when markets fall or buy a type of investment that carries less risk, such as treasury bonds.

Diversifying your portfolio is another option. Wise investors try to balance asset classes, geographic regions, and sectors according to their risk tolerance—or invest in ETFs and mutual funds that are diversified. A diversified portfolio will have a mix of assets that react and perform differently in various market conditions.

Other diversification strategies that investors use include investing in treasury bonds and notes and real estate investment trusts (REITs) funds. There are riskier hedges, such as managed futures and alternative assets, if you have the capital for those.

Each investor is different, with a different tolerance to risk and a different point of view on what even is risk. So selecting the “right” approach to downside protection is a decision best made by each investor.

You don't need to be an expert to invest.

Why is Protecting Against Downside Risk Important?

As with any insurance policy, a downside protection strategy is one of those things investors’ may not need... until they do. The whole point is to have the strategy in place before the unexpected happens and help you better manage risk in your portfolio. In other words, goal-oriented investors play defense to minimize risk to their portfolio no matter what happens.

Market selloffs, like the pandemic-induced stock market selloff in March 2020, are an example of why downside protection is important. Even before that, during the Great Recession, the S&P 500 fell 57.7% from its high in October 2007 before bottoming out in March 2009.

The decline was the largest drop in the S&P index since World War II. That type of decline would take a gain of about 125% just to get back to breakeven. That would be difficult if you are in or near retirement.

Fortunately, investors have a few strategies to protect against losses. However, the strategies come with a downside. Reducing the possibility of a potential loss means that you’re also reducing the possibility of potential profit.

In other words, that slumping tech stock you’d hedged against by purchasing shares in a less-volatile sector might turn around in the next market upswing and make money. You didn’t get that profit, but your peace of mind as you protect your nest egg might be worth it.

How Manage Risk with Downside Protection

Diversifying your portfolio is a downside protection strategy that any investor can use to manage risk. Investors try to keep a balance of investments in a portfolio: different classes of assets, geographical regions, sectors. These hedge, or protect, against the impacts of things like market fluctuations, regional crises, or the drop in demand for a product or service.

Investors regularly should assess the percentage of volatile assets in their portfolio and lower that percentage by rebalancing to include more of one type of asset than another.

Periodically assessing your portfolio for risk and volatility is something every investor should do, but it takes time, even if you keep up with market changes and are familiar with reviewing reports and charts. On Magnifi, you get a chance to see how your portfolio is performing each time you log in.

With Magnifi, your virtual investing co-pilot alerts you to drops in the market that affect the investments in your portfolio—and even gives recommendations for investments that could perform better.

For more experienced investors, hedging is a type of downside protection that investment funds and companies also employ. You might never hedge on your own, but it’s good to understand how a mutual fund in your portfolio might use this strategy to protect the total value of its assets.

Let’s say you purchase shares of your favorite company at $100 per share. However, hearing news about a sustained big drop in the market makes you concerned that the value of your stock could plummet. You decide to hedge your investment by purchasing a “put option”—a contract that gives you the right to sell the stock at a guaranteed “strike price” for a certain period of time.

That way, if the market price drops below $100, you can still sell your shares for your strike price, $100, until the day the put option contract expires. If the price goes up, you let the option expire and all you lose is the premium you paid to buy the put option.

Companies hedge as well. Food companies can hedge prices to lock in prices for a key ingredient, like sugar, while airlines hedge against market swings by locking in the price of fuel. And an international mutual fund might hedge against changes in exchange rates.

Everyone wants to meet their financial goals, from corporations to everyday investors planning for an early retirement or a college fund for their children. Key to successfully hitting those goals is risk management, and downside protection strategies diverse enough for any type of investor.

How to Magnifi Can Help You Find Downside Protection Strategies

Investors who use downside protection strategies also note how their portfolio is performing and how the market is performing. Investors who use Magnifi to invest are able to see this information each time they log in. Check out some of the top downside protection investments you can find, right here on Magnifi.

You can also search on Magnifi for ETFs and mutual funds that aim to provide downside protection strategies. A simple search on Magnifi indicates numerous ways for investors to access these funds with low fees:

References:

"Real Estate Investment Trust (REIT): How They Work and How to Invest," Updated May 24, 2023, investopedia.com, https://www.investopedia.com/terms/r/reit.asp
"How To Rebalance Your Investment Portfolio," June 11, 2023, forbes.com, https://www.forbes.com/advisor/investing/rebalance-investments/#:~:text=Rebalancing%20involves%20buying%20and%20selling,the%20proceeds%20to%20purchase%20bonds.

Disclosures:

Diversification does not guarantee a profit or protect against a loss in a declining market. It is a method used to help manage investment risk.

Exchange Traded Funds (ETF’s) are sold by prospectus. Please consider the investment objectives, risks, charges, and expenses carefully before investing. The prospectus, which contains this and other information about the investment company, can be obtained from the Fund Company or your financial professional. Be sure to read the prospectus carefully before deciding whether to invest.

A REIT is a security that sells like a stock on the major exchanges and invests in real estate directly, either through properties or mortgages. REITs receive special tax considerations and typically offer investors high yields, as well as a highly liquid method of investing in real estate. There are risks associated with these types of investments and include but are not limited to the following: Typically no secondary market exists for the security listed above. Potential difficulty discerning between routine interest payments and principal repayment. Redemption price of a REIT may be worth more or less than the original price paid. Value of the shares in the trust will fluctuate with the portfolio of underlying real estate. Involves risks such as refinancing in the real estate industry, interest rates, availability of mortgage funds, operating expenses, cost of insurance, lease terminations, potential economic and regulatory changes. This is neither an offer to sell nor a solicitation or an offer to buy the securities described herein. The offering is made only by the Prospectus.