As the stock market heads into a new year, it’s been an abnormally long time since we last saw a significant downturn. According to Ned Davis Research, the last 20 percent or greater decline was over 66 months ago which is significantly longer than the average of 21 months between declines of this magnitude. While it’s difficult to predict the future direction of the stock market, a prudent investor knows the market doesn’t rise forever.
Unless you have the (over)confidence to predict when the stock market will go down, there are really only a handful of strategies that reliably reduce the impact of stock declines. I like to use the metaphor of levers that allow you to dial your exposure to the risks (and returns) of the stock market based on your individual circumstances.
Two of the most common levers are your exposure to stocks in general and level of diversification among stocks. It shouldn’t come as a surprise that the amount of stocks you own largely determines the expected risk and returns within a portfolio. For example, owning 80 percent in stocks is going to be riskier than only owning 40 percent. While this is normally the situation, I’ll sometimes see someone with the other portion of their portfolio in non-stock assets which they assume are safer.
Unfortunately, this is not always the case as certain types of bonds or alternative investments can be just as risky as stocks. This unrecognized risk can lead to unexpected results when everything in a portfolio declines in value simultaneously. The solution is to make sure the assets held outside of stocks do not follow the swings of the market too. A common example is the use of bank CDs or short-term government bonds which typically have lower expected rates of return but also don’t lose their value when the stock market declines.
The second lever to use for reducing stock risk in a portfolio is to own dozens (if not hundreds) of individual stocks versus concentrating in just a handful of companies. The potential risk of bankruptcy is much higher for individual companies than it is for a combination of multiple companies. While this may also be common sense, I’ll see exceptions where people concentrate their holdings in particular industries (perhaps as a result of their perceived familiarity with a sector such as manufacturing or IT). An easy way to utilize this lever is through the use of mutual funds which pool investors’ money to buy hundreds of stocks in a single investment.
The primary premise for utilizing both of these levers is to create a portfolio where certain investments “zig” while others “zag.” You may not know in advance which portion will move in a particular direction but the peace of mind from employing these strategies may reduce the anxiety around the uncertainty of future stock market changes.
