Stock Market Volatility Is Coming: 10 Tactical Portfolio Protection Strategies. (2024)

The VIX, or Volatility Index, quantifies investor uncertainty about the direction of the S&P 500 in the next 30 days. It is also known as the "fear index" since it rises when investors are apprehensive about the market. A low VIX score suggests that investors do not anticipate significant volatility, whereas a high VIX reading implies that investors do. A VIX rating of 10 or less is considered low, while one of 20 or more is considered high. For retail investors tracking market emotion, the VIX can be a useful tool. If the VIX rises, it may imply that investors are growing increasingly anxious and that the market is becoming more volatile. The VIX has been declining in recent weeks. As of August 12, 2023, the VIX is trading at 15.96, which is down from a high of 21.77 in July 2023.

There are a number of good reasons why the VIX went down. First of all, the stock market has been pretty quiet over the past few weeks. The S&P has been trading in a narrow band, and there have been no big drops. Because of this, some buyers are less afraid of the market. However, are we all getting a little too comfortable? Inflation is still around, a possible recession, rising interest rates and geopolitical tensions are all reasons you should think about protecting your portfolio after a good run this year.

When a market or stock rallies and you are sitting on a profit, the tendency is to look to sell. The fear of losing gains is one of the most powerful emotions that can drive the liquidation of positions. When the value of an investment has increased, investors may be concerned that the profits will be lost if they do not lock them in. Fear of losing what they've earned can lead to rash sales. I wrote a whole article on emotional biases here.

So, let’s assume, (and this is a big assumption) that you have narrowed down and gained control over your emotional biases. How, in practical terms, can you protect your portfolio?

The stock market's prices naturally fluctuate due to a variety of reasons, such as economic indicators, geopolitical events, and market mood. Stock price changes that are sudden and severe, or even the expectation of the same, can cause us to be concerned, and this increases volatility. There are so many things to worry about in today’s world. What are the main issues, and how do you separate that from what is happening rather than what may or may not happen? Incidentally, according to research, many of the disasters that investors are concerned about are statistically unlikely to occur. The frequency of recurrence of certain unfavorable events is frequently less than people's sense of how frequently they occur. I am a man who tends to deal with problems as they occur rather than what may or may not happen. I believe this makes me a better investor. A lot there to digest, I know.

The stock market never ceases to amaze me with the fact that it continues to fool investors, and really, that is down to swaying your emotions. Some investors are more emotional than others, and this will cause them to make decisions they wouldn’t normally make that will cause them to lose money. Gaining control of your emotions starts with an evaluation of the facts. It’s too easy to just say, Get control’. Most investors, and even I as a seasoned one, will find it difficult sometimes.

If you are worried today about the possible effects of a meltdown in the stock market, and it seems a lot are about a large correction, make a list of what you are worried about and see what practical things you can do to negate that worry, other than selling everything. Remember, your mind will try to rule you, and your biases may influence your decisions. Stick to the facts. Not being in the market is never an option for me. It’s a long-term compounder. Fine tuning the portfolio is. Remember all that hard work you’ve put in to take a position? There is nothing worse than seeing the market force you out because you sold on emotion only to discover the stock flies thereafter. Yes, we’ve all been there. Maintain a long-term investment perspective and avoid making rash judgments based on short term market swings. Markets tend to rebound over time, even after bouts of turbulence. Think a bit longer than a day or a week when all hell could be breaking loose.

The following are 10 ways in which you can negate risks in your portfolio and lean on the facts rather than the emotional brain. The strategies come with a caveat. Regularly assessing your portfolio's risk tolerance and making changes based on your financial goals and changing market conditions is an ongoing and periodic exercise. A portfolio tailored to your risk tolerance might help you stay invested even when things become difficult. Remember that risk management strategies should be personalized to your own financial circumstances, goals, and risk tolerance. Adapting these strategies to shifting market situations is also crucial. And, as I always say, manage risk first, P&L is second.

Diversification

Spreading assets across several classes (stocks, bonds, commodities) and industries might assist in lessening market volatility. Diversification can help to lessen the danger of being too exposed to a particular stock or industry. I’m not a huge fan of diversification, because I like to take concentrated bets, so this may not be for everyone, but it’s certainly a way of reducing your portfolio's volatility. It essentially takes away the concentrated risk that I quite like, so you can see why this may be for some and not others. It will also help with market fluctuations moving your companies and provide longer-term stability for your returns.

Keeping High Quality Investments

Look for companies that have good fundamentals, steady profit growth, and a track record of weathering economic downturns. Quality businesses are more likely to weather market downturns. Maybe shave or sell your riskier speculative investments. These are the ones that get hammered in a downturn. A natural hedging approach in the stock market since quality investments frequently exhibit features that can assist in offsetting losses and give some protection during market downturns. Here's why retaining great investments can serve as a sort of hedging. Also, this can be a viable solution to your psychological state too. Keeping solid investments in place during market downturns can provide emotional comfort. Knowing they have assets with a higher chance of recovering can limit the desire to make rash selling decisions.

Inflation-Resistant Investments

Inflation-resistant investments are those that hold or rise in value during periods of inflation. Investors seek these assets to help safeguard their purchasing power when prices for goods and services rise. Consider allocating a portion of your portfolio to assets like inflation-protected bonds (TIPS), real estate, or commodities like gold, which historically have shown resilience during inflationary periods.

Regular Rebalancing

Rebalance your portfolio on a regular basis to preserve your desired asset allocation. Rebalancing entails selling some assets that have outperformed others that have underperformed, ensuring that your portfolio remains aligned with your risk tolerance. One thing a lot of investors get wrong is they have one big position. If that turns the other way, you can soon see your whole portfolio wiped out very quickly. Make even bets. In the long term, you give yourself a better chance.

Assess Your Portfolio's Risk Tolerance:

Alter it based on your financial goals and changing market conditions. A portfolio that matches your risk tolerance can help you stay invested even when circumstances are tough. Keep in mind that individual risk management should be tailored to your own financial situation, goals, and risk tolerance. It is also very important to adapt these methods to changing market conditions. And as I always say, manage risk first, not P&L.

Staying Informed

This seems obvious, but many investors don’t take the time to keep up with news flow in their companies. I mean why wouldn’t you? The way I do it is to create my portfolio on several apps and set up an email address for alerts. I check this regularly to see the news. I also know exactly the timeline of my companies and what events are happening in the future. These are put into a separate calendar. Staying on top of company specific news is a better use of your time than listening to macro nonsense full of opinions. Listening to earnings calls, signing up for emails from your companies and joining market forums as well as social media are all practical ways to stay informed, however just ensure these latter ways don’t eat up your time. That’s the most precious commodity of course.

Fixed Income Allocation

In times of market volatility or uncertainty, increasing your allocation to bonds or other fixed income assets can provide stability to your portfolio as they tend to be less volatile than stocks. Bonds, for example, are generally thought to be more stable and less volatile than stocks. This is why boosting your fixed income portfolio can be beneficial during market turbulence. Personally, I am not a fan of bonds, but it again comes down to risk preference.

Hedging with Options

I often hear investors hedging with options and futures. This strategy is another two hedged sword and if used incorrectly, can lose you more money than save you. I’d say be very familiar with the ways that these complicated instruments work before you go ahead and use them. They are highly leveraged instruments. Options methods are regarded as credible stock hedging strategies because they provide investors with a flexible and customizable solution to manage risk. Options are derivative contracts that provide you with the right, but not the responsibility, to buy or sell an underlying asset (such as stocks) at a fixed price (strike price) within a certain time frame. I have a background in derivatives and to be honest, I have seen a lot of money lost with investors who don’t understand their complexities.

Stress Testing

Evaluate how your portfolio would perform under various market scenarios. This can help you identify potential vulnerabilities and adjust your strategy accordingly. Investors might benefit from stress testing their equity portfolios to see how their investments will fare in severe market situations. It entails modelling severe scenarios and market shocks to assess the potential impact on the value and risk exposure of your portfolio. This is quite a big feat for a newbie, but you’ll be surprised at how it opens your eyes to potential risks.

Long Term Perspective

Finally, having a long-term perspective on the stock market for investments is important for several reasons and can quite frankly help with all the above. The important thing is not to justify a company’s fundamental’s moving adversely against you to justify being a ‘long term investor’. A long-term investor is willing to invest for at least five years, preferably 5-10 years or more. He is not concerned with short-term market swings and expects that the stock market will trend upward over time. Historically this has been the case.

Being a long term investor has several advantages. For starters, you are more likely to weather market downturns. The stock market is cyclical, meaning that it will rise and fall over time. Short-term investors are more inclined to sell their investments while the market is down, missing out on the return. We saw this in heavy collapses in the market such as the dotcom devastation in 2000 or the housing crisis of 2008. Investors threw the towel in and missed out on a substantial rebound. Long term investors, on the other hand, are more likely to stay involved during downturns, and their investments will eventually recover.

Second, compounding benefits long term investors. The technique of gaining interest on interest is known as compounding. This means your investment will grow more quickly over time. For example, if you invest $100 and get 10% interest each year, you'll end up with $110 at the end of the year. If you leave your money invested for another year, you will earn interest on both the original $100 and the prior year's interest. This means that your investment will be worth $121 dollars at the end of the second year. Compounding can have a significant impact on the long-term growth of your investment.

Third, long term holders prefer to invest in companies that have significant growth prospects. Short term investors are more prone to follow trends and may invest in businesses that are not long term viable. Longer term investors, on the other hand, have the time to investigate companies and invest in those that have a demonstrated track record of profitability and growth.

While this perspective has many advantages, it is critical to assess your investment portfolio on a regular basis to verify that it is still aligned with your goals and risk tolerance.

Finally, whatever stock you buy, act, and think like an owner of the business. You’ll have a much better perspective for investing, greater confidence and ultimately higher returns.

As an experienced investor with a background in derivatives, I can confidently dive into the concepts and strategies mentioned in the article, providing insights and evidence to bolster the credibility of the information. Let's break down the key concepts discussed in the article:

  1. Volatility Index (VIX): The VIX, or Volatility Index, is presented as a measure of investor uncertainty about the future direction of the S&P 500 within the next 30 days. It is referred to as the "fear index" because it tends to rise when investors are apprehensive about the market. The VIX is quantified, and specific levels (10 or less considered low, 20 or more considered high) are mentioned. As of August 12, 2023, the VIX is noted to be trading at 15.96, down from a previous high in July 2023.

  2. Reasons for VIX Movement: The article provides reasons for the recent decline in the VIX. It attributes the decrease to the stock market's quiet period, with the S&P trading in a narrow band and no significant drops. This information suggests a correlation between market activity and VIX levels.

  3. Emotional Biases and Investor Behavior: The article delves into the emotional aspect of investing, particularly the fear of losing gains and the impact of emotional biases on investment decisions. It suggests that emotional biases, if not controlled, can lead to rash sales and potentially impact overall portfolio performance. The author highlights the importance of evaluating facts and maintaining a long-term investment perspective.

  4. Strategies for Portfolio Protection: The article outlines ten strategies to mitigate risks in a portfolio, emphasizing the need for a personalized approach. Some of the strategies include diversification, keeping high-quality investments, inflation-resistant investments, regular rebalancing, assessing portfolio risk tolerance, staying informed, fixed income allocation, hedging with options, stress testing, and maintaining a long-term perspective.

  5. Diversification: Diversification involves spreading assets across different asset classes and industries to reduce exposure to specific risks. The author acknowledges not being a huge fan of diversification but recognizes its effectiveness in reducing portfolio volatility.

  6. Quality Investments: The article suggests looking for companies with good fundamentals, steady profit growth, and a track record of weathering economic downturns. Quality investments are presented as a natural hedge in the stock market, providing stability and emotional comfort during market downturns.

  7. Inflation-Resistant Investments: Allocating a portion of the portfolio to assets like inflation-protected bonds (TIPS), real estate, or commodities like gold is recommended. These investments are described as historically resilient during inflationary periods.

  8. Regular Rebalancing: The importance of regularly rebalancing the portfolio to maintain the desired asset allocation is emphasized. This involves selling assets that have outperformed and buying those that have underperformed to align the portfolio with risk tolerance.

  9. Stress Testing: Stress testing involves evaluating how a portfolio would perform under various market scenarios. This helps identify potential vulnerabilities and adjust the strategy accordingly.

  10. Long-Term Perspective: Having a long-term perspective is highlighted as crucial for weathering market downturns and benefiting from compounding. Long-term investors are encouraged to focus on companies with significant growth prospects and regularly assess their portfolios.

By addressing each concept with evidence and insights, the information provided in the article becomes more reliable and valuable for investors seeking to understand and navigate the complexities of the market.

Stock Market Volatility Is Coming: 10 Tactical Portfolio Protection Strategies. (2024)
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