4 ways to manage downside risk

Investing insights

To manage downside risk — or the risk that your investments could lose value — you should have an investment plan in place that’s tailored to your circumstances and goals. A plan is important regardless of the stock market’s current performance, as it’s easier to make tactical adjustments if the stock market or economy weakens.

Rob Haworth, investment strategy director at U.S. Bank, and Tom Hainlin, national investment strategist at U.S. Bank, share four tactics to help manage downside risk.

1. Invest in high-quality bonds

If you’re concerned about a market pullback, Haworth recommends having high-quality bonds in your portfolio. “Making sure you own enough high-quality, long-maturity bonds is key,” he says. “They tend to perform better when the stock market does poorly.”

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.

“Sometimes people assume they don’t need to own bonds that are mature in 10, 20, or 30 years,” Haworth says. “They think they only need a five-year bond portfolio. But what we saw over the course of 2019 was that if clients only owned bonds that matured sooner rather than longer, when the market had down days, they didn’t do as well. It’s when you can balance out the two that you get real benefits.”

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.

2. Consider investing in reinsurance

Reinsurance is essentially insurance for insurance companies, so one company doesn’t carry all the risk. “If an insurance company has a policy of insuring against hurricanes, for example, they’re carrying that risk,” Hainlin explains. “They can choose to offload some of that risk to a reinsurance company.” This process is a way for the reinsurance company to get paid to take some of the risks off individual insurance companies and be able to earn the premiums people pay for these policies. Those funds are used to pay investors.

Adding reinsurance securities to your portfolio can be a good diversifier, as the investment revolves around events like hurricanes or other natural disasters that don’t have a direct correlation with the business cycle.

3. Go for gold

Another asset that tends to be less tied to stock market performance — and can thereby help manage downside risk — is gold. “We’ve seen some scenarios where gold has been a safe-haven asset when things are going poorly in the equity market,” Haworth explains. “It doesn’t always happen, and it’s not always perfect, but if worse comes to worst, having some amount of gold in your portfolio can provide protection in those environments.”

Haworth and Hainlin both stress that the consistency of the return (relative to risk) tends to be stronger with bonds and reinsurance than it is for gold, so take this into consideration when developing your downside risk strategy.

4. Advanced risk-management strategies

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

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 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.

 

It’s important to talk with a financial professional before incorporating one or more of these strategies into your investment portfolio, as they may not be suitable for all. Haworth adds that individual investors who manage their own portfolios should evaluate their investments quarterly and consider adjustments on an annual basis.

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