Downside risk: Understand and manage it

After nearly a decade of consistent market growth, investors are turning their attention to protecting gains. After all, the last two bull markets — the dot-com bubble burst in the early 2000s and the housing and financial crises of 2008 — both ended sharply.

To help take the edge off sudden changes, Rob Haworth, senior investment strategy director for U.S. Bank Wealth Management, recommends developing a plan to help protect your investments. To do that, it’s helpful to understand some of the factors that could affect the market going forward.

The impact of rising rates

The Federal Reserve (the Fed) is in the middle of an ongoing plan to increase interest rates, and while the timing of future increases remains uncertain, some investors are concerned additional rate hikes will stall economic growth.

“There’s a perception that rising interest rates are bad or will have negative effects on investments broadly,” says Tom Hainlin, national investment strategist for U.S. Bank Wealth Management. However, it’s important to remember low rates are not necessarily good for growth, and high rates are not necessarily bad for it.

Rates are adjusted based on two factors: employment and inflation. “Asset classes will perform differently if interest rates are rising because inflation is rising or they’re rising because the economy is doing well,” Hainlin says.

While the Fed had been raising rates due to a strong economy and low unemployment, the Committee announced it will be patient as it determines what future adjustments are appropriate to support objectives.

The China question

While Hainlin cautions making long-term investment decisions based on political rhetoric, investors should still pay attention to what’s going on in China. “[It’s] the second biggest economy in the world,” he says. “It has an outsize impact on the world economy, and any slowdown there would have spillover effects elsewhere.”

Having a plan in place makes it easier to make tactical adjustments to your investments if you expect the stock market to drop or the economy to weaken.

Despite posting consistently high economic growth numbers, there are some signs of weakness in China. Consumers seem to be spending less, and the Chinese government is investing less in its large infrastructure projects.

In addition, exports account for nearly 20 percent of China’s GDP, and the U.S. and China are locked in a showdown over trade and tariffs. Tensions could escalate into a trade war, affecting investor sentiment and stock prices, says Hainlin.

Steps for managing downside risk

To manage downside risk — or the risk that your investments could lose value — all investors should have an investment plan tailored to their circumstances and goals. These plans are important regardless of the stock market’s current performance. Having a plan in place makes it easier to make tactical adjustments to your investments if you expect the stock market to drop or the economy to weaken.

If you’re concerned about a market pullback, Haworth says the first tactical adjustment is to ensure your portfolio has enough high-quality bonds.

What constitutes “enough” will vary by investor. Investors near retirement age with a conservative risk tolerance will likely seek a higher allocation of bonds than young investors just starting out. The quality of bonds matters, too. If you’ve been investing in high-yield (or junk) bonds, you might consider replacing these bonds with less risky alternatives. Individual investors who manage their own portfolios should evaluate their investments quarterly and consider adjustments on an annual basis, Haworth says.

Advanced risk-management strategies

Some investors want security beyond a shift in their allocations. When appropriate, derivatives and structured products may be a good option.

Derivatives — so named because they derive their value from an underlying asset — allow investors to hedge or speculate with less capital and without purchasing the security outright. Some traders and investors use derivatives (for example, options) as a way to hedge risk.

Structured products come in many forms but often consist of multiple derivatives packaged together. Structured products provide returns based on the performance of the underlying security, without requiring you to purchase the security directly.

Both derivatives and structured products are complex, generally illiquid, carry significant risk and may require active management. They can also help investors hedge stock investments without shifting their portfolios entirely to bonds. “If you’re worried about a potential decline in stock prices, derivatives and structured products can be a useful tactic,” Hainlin says.

Investors interested in these types of strategies should talk to a wealth management professional from U.S. Bank and U.S. Bancorp Investments and understand the suitability for their use before incorporating them into a portfolio.