Key takeaways

  • Managing downside risk – the risk of loss in an investment, is critical to help individuals meet long-term investment objectives.

  • Investors today should be prepared for potential volatility as markets adjust to a changing economic and interest rate environment.

  • A variety of strategies can be considered to help mitigate risk of losses across your portfolio.

Investors remain on alert for volatile markets after a negative 2022 for stocks and bonds was followed in 2023 by a sharp recovery for some stocks and a mild recovery for bonds. It’s a reminder that markets can be unpredictable in the short term, and investors should consider strategies 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.

“The challenge today is that while parts of the stock market have reached all-time highs, the results overall are mixed,” says Rob Haworth, senior investment strategy director at U.S. Bank. “Investors should prepare for ongoing choppiness in the months to come.” Given the reality of market unpredictability, developing a long-term investment strategy can play an important role in your long-term financial plan. From that point, if you choose, you can make tactical adjustments to reflect changing market conditions.

“The challenge today is that while parts of the stock market have reached all-time highs, the results overall are mixed,” says Rob Haworth, senior investment strategy director at U.S. Bank Wealth Management. “Investors should prepare for ongoing choppiness in the months to come.”

What is downside risk?

Downside risk is the potential that your investments could lose value during certain short-term time spans. Stock and bond markets may generate positive results historically over time; however, during certain periods, markets or specific investments you hold can move in a negative direction. Avoiding significant losses in your portfolio is an important factor in determining whether you succeed in achieving your long-term financial goals. Applying diversification strategies to mitigate downside risk can help.

 

What is a downside risk event?

At times, markets are subject to short-term price swings due to specific events that affect investment performance. A recent example is the onset of the COVID-19 pandemic in early 2020. The global economy slowed considerably as schools, workplaces and stores closed. In this period of uncertainty, the U.S. stock market, as measured by the Standard & Poor’s 500 Index, lost 19.6% over the first three months of 2020. This environment may have caused investors to reposition assets in a way that was contrary to their long-term investment strategy.

 

What is downside risk protection?

Protection against downside risk can involve incorporating investment strategies designed to limit potentially negative results for a portfolio. Haworth and Tom Hainlin, national investment strategist at U.S. Bank Wealth Management, share four tactics to help manage downside risk.

 

1. Invest in high-quality bonds

If you’re concerned about a market pullback, Haworth recommends including high-quality bonds in your portfolio. “Making sure you own an appropriate position in high-quality, long-maturity bonds is key,” he says. “Bonds tend to provide stability to a portfolio in periods when equity markets experience volatility.” Haworth says with interest rates elevated, bonds may offer an attractive opportunity. “Today’s bond market offers the potential to earn higher yields than was the case just a couple of years ago,” says Haworth. “It makes it possible to achieve long-term investment goals while reducing portfolio risk.”

Chart depicts month-end 10-yr U.S. Treasury Yields January 2020 - January 2024.
Source: U.S. Department of the Treasury, Daily Treasury Par Yield Curve Rates. As of January 31, 2024.

Determining a sufficient weighting in bonds will vary by investor. Those near retirement age with a more conservative risk profile will likely seek a higher allocation of bonds than young investors who are decades away from retirement. The bond quality 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 mature in 10, 20, or 30 years,” Haworth says. “They think they only need a five-year bond portfolio. But we’ve seen that if clients only own bonds that mature sooner rather than later, when the market has down days, portfolio performance lags. Instead, we’d recommend a balanced portfolio that includes a diversified mix of shorter and longer-term bonds.”

 

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 taking on significant risk,” Hainlin explains. “They can choose to offload some of that risk to a reinsurance company.”

Reinsurance companies are compensated to take on some of the risks typically carried by individual insurance companies. Reinsurance companies generate an income stream for investors in the form of premiums paid by the companies they insure.

For appropriate investors, adding reinsurance securities to a portfolio can provide effective diversification, as the investment revolves around events like hurricanes or other natural disasters that don’t have a direct correlation with the business cycle. Reinsurance-related securities generally generate competitive returns, particularly with fixed-income investments with a low level of volatility (variation in annual performance).

Performance Results of Major Asset Classes

Source: Morningstar. Data based on performance from Aug. 1, 2008, through December 31, 2023.

Asset Class

Annualized Return

Annualized Volatility

Foreign Emerging Mkt. Stocks

13.19%

29.44%

Mid Cap Stocks

13.00%

19.41%

Large Cap Stocks

12.00%

17.07%

U.S. REITs

11.65%

21.05%

Small Cap Stocks

11.45%

19.21%

Foreign Developed Mkt. Stocks

9.33%

19.10%

High-Yield Corporate Bonds

8.49%

15.93%

Reinsurance

7.13%

5.52%

Municipal Bonds

3.84%

4.77%

Investment Grade Bonds

3.33%

4.77%

Asset Class

Foreign Emerging Mkt. Stocks

Annualized Return

13.19%

Annualized Volatility

29.44%

Asset Class

Mid Cap Stocks

Annualized Return

13.00%

Annualized Volatility

19.41%

Asset Class

Large Cap Stocks

Annualized Return

12.00%

Annualized Volatility

17.07%

Asset Class

U.S. REITs

Annualized Return

11.65%

Annualized Volatility

21.05%

Asset Class

Small Cap Stocks

Annualized Return

11.45%

Annualized Volatility

19.21%

Asset Class

Foreign Developed Mkt. Stocks

Annualized Return

9.33%

Annualized Volatility

19.10%

Asset Class

High-Yield Corporate Bonds

Annualized Return

8.49%

Annualized Volatility

15.93%

Asset Class

Reinsurance

Annualized Return

7.13%

Annualized Volatility

5.52%

Asset Class

Municipal Bonds

Annualized Return

3.84%

Annualized Volatility

4.77%

Asset Class

Investment Grade Bonds

Annualized Return

3.33%

Annualized Volatility

4.77%

Source: Morningstar. Data based on performance from Aug. 1, 2008, through December 31, 2023.


3. Go for gold

Another asset that tends to be less correlated 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 a modest portfolio position in gold can provide protection in those environments.”

Although prices recently stabilized, gold prices are still higher today than they were in recent years.

Table depicts gold prices per ounce 2020 - January 31, 2024.
Source: WSJ.com, Gold Continuous Contract, U.S.: Nymex. As of January 31, 2024.

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 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 a direct security purchase.

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.

 

Develop a personalized risk-management strategy

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 annual adjustments reflecting investment performance.

Learn about our approach to investment management.

 

Reinsurance allocations made to insurance-linked securities (ILS) are financial instruments whose performance is determined by insurance loss events primarily driven by weather-related and other natural catastrophes (such as hurricanes and earthquakes). These events are typically low-frequency but high-severity occurrences. In exchange for higher potential yields, investors assume the risk of a disaster during the life of their bonds, with their principal used to cover damage caused if the catastrophe is severe enough.

There are special risks associated with an investment in gold, including market price fluctuations, liquidity risks and the impacts of political, environmental and financial changes. In addition, unique expenses associated with these investments (i.e., purchase and sale, appraisal costs, storage, insurance) may adversely impact investment returns.

Derivatives can be illiquid, may disproportionately increase losses and may have a potentially large negative impact on performance. Employing leverage may result in increased volatility. These investments are designed for investors who understand and are willing to accept these risks.

Related articles

How to invest in bonds for portfolio diversification

Bonds are a common investment in times of economic uncertainty, but they also play an important role in diversifying your portfolio.

How diversification in investing may reduce risk

Why is diversification important in investing? Because risk never disappears – even in times of economic growth.

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