Market volatility can have a way of derailing your best-laid investment strategy. So, what can you do to reduce risk when markets move against you? Stay invested and get back to the basics. As with most life situations, when circumstances put up roadblocks to your goals, your first response may be to double down on your current approach instinctively. However, doing more of what you already have done may not only deplete your resources, it may also exacerbate an already untenable situation.
That’s why when markets start moving against you, one of the best things you can do from an investment perspective is to focus on the essentials. While it may be tempting to get out of the markets altogether, fine-tuning some components of your investment strategy could otherwise set you up for long-term success. These steps include evaluating your exposure to market risk, focusing on higher-quality investments, reducing leverage, and diversifying your portfolio. To be sure, taking these actions may enable you to stay in the game for the long-run and improve your odds of achieving your financial goals.
Step 1: Evaluate Your Market Risk Exposure
The first essential step you should take when markets start moving against you is to evaluate your exposure to market risk. Beta is one way to quantify this risk, and reducing exposure to it may help you better navigate sharp market swings. Why? Investments with high beta tend to experience outsized moves relative to the broader market when risk assets rally or decline. So, what is beta?
Well, beta is a statistical representation of the movements between a security and a broad measure of the financial markets, like the S&P 500 index. A positive value suggests that a security might move in tandem with the broader markets. Assets with a negative beta tend to move in the opposite direction of the broader markets, while a zero beta suggests little affect in its price relative to the broader markets. And which assets are more prone to move with sharp swings in the markets? Let’s look at an example.
History tells us that cyclically oriented equity sectors, like financials, energy, and materials, tend to follow the broader market’s moves higher (and lower). On the other hand, fixed income assets like Investment Grade and US Government bonds are less inclined to follow the direction of the broader markets and, in some cases, move in the opposite direction.
Beta is particularly useful when uncertainty rises, and your priority is to reduce the level of swings within your investment portfolio. Holding too many high-beta securities can leave your savings exposed to unnecessary risks and increases the likelihood that you’ll fall short of your financial goals when risk assets suddenly decline in value. That’s why when market volatility picks up, identifying an appropriate mix of high- and low-beta investments in your portfolio may be vital to reducing investment risk, particularly as you near your savings goals.
Step 2: Move Up in Credit Quality
The next step you should take in getting back to investing basics is evaluating your bond exposure and consider moving up in credit quality. Assuming that merely having exposure to bonds in your investment portfolio is a way to hedge against volatility could be a recipe for disappointment. To be sure, not all bonds offer safety from market swings.
This point is evident in how yield spreads of low-quality bonds tend to rise during periods of heightened market volatility. Historical data show that when the VIX (a measure of market volatility) rises, the price of lower quality bonds falls, and yields move higher relative to higher-rated fixed-income assets, like government bonds.
In fact, history has shown that the spread between high yield and US government bonds can widen by as much as 20% during periods of heightened market volatility. For example, during the market selloff in early 2020, spreads went from less than 4% in January to 11% in March. Such price behavior not only reflects lower risk appetite among market participants, but it also represents a desire among some investors for higher compensation to take on additional risk. This is notably the case for assets that may have a higher degree of financial uncertainty when economic conditions underpinning the securities deteriorate.
As noted earlier, higher beta fixed income assets, like high yield bonds and emerging market debt, tend to move in the same direction as risk assets, like stocks. Indeed, while bonds might be perceived as a more conservative investment, the truth is that certain cash flow, industry, or country characteristics can make them higher-risk investments and susceptible to market ebbs and flows. That’s why if you’ve been using bonds as a way to gain additional yield in your portfolio, you may want to consider higher quality and lower beta fixed-income assets as a way to reduce investment risk.
Step 3: Consider Cheaper Stock Alternatives
After you’ve evaluated risk exposure and the credit quality of your bonds, the next thing you might want to think about during a market pullback is whether you’re paying too much for stocks. It might go without saying that buying low and selling high is vital to long-term investing success. And while momentum, or recent price action can be an informative value indicator, you may want to consider valuation factors like price-to-earnings (P/E) ratios to determine whether you’re paying too much for a given asset.
Why do valuations matter? While it’s true that even some high P/E growth stocks can provide investors with positive returns, history suggests that lower P/Es are often associated with more favorable investment outcomes. To evaluate how well this relationship holds, we looked at the historical relationship between P/E ratios for the S&P 500 and subsequent returns over a one-year period. What did we find?
Well, with data going back to the 1930s, our work shows that if you held a portfolio tracking the S&P 500 index when its P/E ratio fell two standard deviations below its mean, you could have received an average annual return of 14%. And how does this compare with purchasing a similar basket of stocks when P/E’s are excessively high? Well, buying stocks when they’re expensive generated an average 8% returns in the following one-year period.
While our analysis shows that buying high P/E stocks also produced positive returns, the simple truth is that lower P/E stocks tend to outperform over time. The point here is that when the market begins to move against you, one way to set yourself up for a favorable investment outcome is to consider cheaper stock alternatives than what you may already be holding. This includes keeping an eye on high quality, low valuation opportunities.
Step 4: Reduce Portfolio Leverage
For some investors, trending market behavior presents an opportunity to use borrowed money to boost investment returns. This strategy can work well when prices are moving higher but can amplify losses during a pullback. That’s why when markets start moving against you, another critical factor to consider is reducing leverage in your portfolio. Let’s take a closer look at how this works.
Leverage usually involves opening a margin account with your brokerage firm, depositing 50% of the value you wish to borrow (this is called initial margin), and hoping that the asset you purchased continues to appreciate. Simple enough, right?
Well, while the value of your portfolio may rise and fall with the markets, the loan you received typically stays fixed. What’s more, your broker will also require that your levered investment maintain an equity-to-debt ratio above a certain threshold (maintenance margin). This approach might work well as markets head higher, but when they fall, a time might come when you’ll need to raise cash to bring your equity position above the maintenance margin requirement or sell some of your stock to make your broker whole.
And it goes without saying that being forced to sell during a downturn to cover a margin call can amplify losses. That’s why overseeing leveraged positions and avoiding a margin call is crucial to managing investment risk during uncertain times. To help illustrate the point, consider the performance of two portfolios that bought on margin heading into a market downturn.
Example: Margin and a Downturn
Let’s say that you decide to invest $100,000 into ABC company using $70,000 cash, and $30,000 borrowed from your broker. In this situation, we’d say that your portfolio is 30% leveraged. After initially gaining in value, your portfolio experiences a 40% drawdown over two weeks. While your portfolio avoided a margin call, your net return after accounting for the loan is -48%. To put this number into context, the loss on an all-cash portfolio during this time could be -33%.
And how would this situation look if you had borrowed more money from the start? Well, let’s assume that you use $100,000 to purchase the same security, this time with 50% of your broker’s money. During the same market downturn, your net return after accounting for the margin loan declines -67%. This two-thirds decline is amplified by a broker’s margin call, theoretically leaving you with a more significant hole to climb out of.
The key takeaway here is that if you’re using leverage to gain an investing edge, then one of the first steps you should take when the markets are moving against you is to evaluate your use of margin. While this resource can undoubtedly help boost returns when markets are trending higher, it can also open you up for excessive losses during periods of heightened market volatility.
Step 5: Diversify Your Portfolio
A final but crucial step to reducing investment risk during times of uncertainty is to diversify. Diversification can help smooth out investment returns and, more importantly, lessen volatility when the markets begin to move against you. Why is diversification important?
Well, few individuals can predict with certainty which investments will perform well in any given year. In fact, history has shown that an outperforming sector or asset class one year often loses favor with market participants the following year.
For example, if you held one of the largest names in the S&P 500 index, what you’re likely to have experienced over the past few decades is annualized volatility as high as 40%. Put differently, while your stock might have an average return of 10% in a given year, that value could swing between a 30% loss, a 50% gain from one year to the next.
This varying performance can be problematic if you’re near a critical savings goal and is how diversification comes help. A simple analysis shows that combining just five stocks from the S&P 500 index could cut your portfolio volatility in half from 40% to 18%. In fact, adding 30 stocks to your portfolio might reduce volatility by two-thirds.
The point here is that diversifying your portfolio lets you gain exposure to market returns without having to pick a winner while taking excessive risk rather than trying guess which investment might do well from one year to the next. When paired up with assets of varying correlations, diversification has historically demonstrated its ability to reduce volatility and smooth out portfolio returns.
Get Back to Investing Basics When Markets Move Against You
As with most life situations, when circumstances put up roadblocks to accomplishing your goals, your first response may instinctively be to double down on your approach as a way to achieve success. Doing more of what you already have done, however, may not only deplete your resources, it may also even exacerbate an already untenable situation.
That’s why when markets start moving against you, one of the best things you can do from an investment perspective is to focus on the essentials. While it may be tempting to get out of the markets altogether, shifting your investment strategy could be a better set up. These steps include evaluating your exposure to market risk, focusing on higher-quality investments, reducing leverage, and diversifying your portfolio. Taking these actions may enable you to weather a downturn, stay in the game for the long-run, and improve your odds of achieving financial success.