Do you need to crash-proof your portfolio? We’re in the midst of market that has returned over 400% since March 2009, which was the last time the market experienced sustained selling pressure (the covid-induced crash last year saw the Dow lose 35% in a month, compared to the Great Recession which saw the Dow lose 50% over an 18-month period).
Since 2007, the Dow Jones Industrial Average has gained more than 20,000 points, but the ride has not been without volatility (the recent market swings on the back of Fed tapering news, omicron, inflation and Russia has put the VIX at elevated levels once again).
However, what goes up must come down, and while I am all about finding fabulous-and profitable-recommendations for my readers, I would be remiss if I didn’t also offer ideas to protect my readers’ portfolios in times of pullbacks or excessive volatility.
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Don’t make the same mistake that many investors make: Although they love to buy stocks, they hate to sell them.
When the market looks enticing, many investors become so excited that they buy stocks willy-nilly, with no thought to creating a balanced portfolio. And when the market drops, they freeze, not knowing whether they should continue to buy more shares to take advantage of the lower prices or just bail out and sell everything. And the sad result is usually this: When under pressure, investors will generally make exactly the wrong decision!
In essence, they fail to plan.
But you don’t have to make the same mistakes. Instead, with a little thought and planning, you can create an all-weather portfolio.
For the last few weeks, investors have been on a market seesaw, with hundred point daily gains and losses almost becoming the norm. In such volatile markets, it’s more important than ever that you not only consider investing for gains, but also invest to protect your existing portfolios.
Now, I’m not saying you won’t ever lose money, because there are no guarantees in the stock market. But here are steps you can take to minimize your losses and also maximize your profits.
4 Steps to Crash-Proof Your Portfolio
Crash-Proof Your Portfolio Step 1. Set a price target the day you purchase your stocks.
Your target should be based on the P/E of your stock, multiplied by expected future earnings. I recommend that you at least think about what price your stock can achieve within 18-24 months. And that should at least be a 30%-50% gain. If your stocks don’t have that potential, keep looking.
When the stock hits your target, reevaluate it and determine if it has the potential to continue double-digit price gains or if you would gain more by cashing in and using those funds to purchase a different stock with more potential. Many of the contributors to the Investment Digest make this decision easy for you, by providing targets for their recommendations, and often cash in just a portion of a holding to take some profits and let the remaining half ride toward a new target.
Crash-Proof Your Portfolio Step 2. Set a stop-loss limit the day you purchase your stocks.
For aggressive investors, the stop-loss could be 30% or more. For more conservative investors, you might be happier with a stop-loss of 10%. It should generally factor in the volatility of the underlying stock. The actual percentage is not as important as being disciplined in exercising the stop losses. Sure, no one likes to lose money, but a stock riding momentum down can clean you out in no time, so it’s best to take your losses. If the stock bounces back, you can always buy back into it. Many of our contributors provide stop losses for you, but it’s always a good idea to consider your own investing strategies when setting your stop losses.
Crash-Proof Your Portfolio Step 3. Diversify your portfolio to reduce your overall portfolio risk, as well as volatility.
That means creating a portfolio with non-correlating assets, which, theoretically, results in assets that react differently to market catalysts. When market action causes some of your assets to decline in value, others should rise, effectively providing protection against your entire portfolio declining at the same time.
Consequently, you should own small-, mid- and large-cap stocks; companies in different sectors; and both value and growth stocks.
And while you may think you are properly diversified because you may have 10 different technology stocks that operate in totally different segments, remember that they are all still technology stocks-companies that tend to do very well when the economy is steaming ahead and customers have plenty of money to upgrade.
Make sure you diversify across a broad range of sectors.
You should also have exposure to international stocks, either through owning multinational companies or via exchange-traded funds. And don’t forget about fixed income investments. As well, some investors may want to add currencies, commodities and real estate to their portfolios.
Of course, the actual composition of your portfolio will depend on your personal investment goals, your age and your risk profile, so make sure you know the kind of investor you are so that your portfolio will match up to your goals.
Crash-Proof Your Portfolio Step 4. Put some dividend-paying stocks in your portfolio.
They are a great hedge against inflation and provide terrific portfolio gains in down market cycles. Years ago, during the tech boom, I began adding dividend stocks, such as regional banks and Real Estate Investment Trusts to my portfolio. The payoff was great! When the tech stocks bit the dust and the market took a downturn, I was still earning great returns on my dividend stocks. Many investors neglect these companies as they think they are too boring. But, what’s boring about making money?
With so much cash available to companies over the past few years, stocks in every sector—including technology and emerging markets—will often pay a dividend. And that just adds to your profits.
For most investors, following these four steps will help you create a portfolio that will thrive through normal up and down market cycles. While an undiversified portfolio can give you tremendous gains—if you are lucky enough to choose only “home-run” stocks—the plain truth is that most investors-individual or professional-don’t have a crystal ball. And stocking your portfolio with just one type of company or sector—no matter how promising—is a recipe for failure over the long term.
What steps do you take to protect your portfolio during periods of higher volatility?
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*This post has been updated from a previously published version.