5 Ways To Protect Your Investment Portfolio in a Downturn

I don't know about you, but I'm ready for 2020 to be gone, and like many of you, my year started great. Then came that nasty little germ that we now know as COVID-19. It's impacted many of our careers and turned what we used to call routine upside down. 

Like all of you, I'm tired of thinking and talking about COVID-19. Yet here we are talking about it again. Before you tune out thinking this post is going to be another Debbie Downer or Negative Nellie rant, let me assure you, it's not.

However, it's essential to consider how best to protect ourselves, our families, our homes, and our environment during these times in these uncertain times. Whether you're in the upper 1% or the bottom half, it's likely everyone has investment portfolios of some sort. That might mean your retirement plans (401(k) or individual IRAs). Or it could be something much more significant than that. The size of your portfolio doesn't matter for this discussion.

Everyone who has money invested is concerned about how to protect those investments during these uncertain times. In March, many of us found out just what it's like to endure massive swings in the stock markets. We saw our portfolios drop dramatically (in many cases) and bounce back up in a dramatic fashion.

These price swings can be quite disconcerting. So, how do we protect our investment portfolio in these big market swings? What, if any, steps can we take to cushion the blows without sacrificing returns?

Today, I want to offer you five simple things you can do to protect your investment portfolio during these volatile times.

Protect Your Investment Portfolio

1. Have a Plan

If you're investing isn't done with some plan, it will be next to impossible for you to succeed. The plan guides everything else we'll be discussing in the following sections. Your plan guides your investment decisions. You have to have a purpose behind the portfolio.

There are several ways to look at planning. For me, it starts with the questions, “What do you want your investments to do for you?” Is it to fund or supplement your retirement income? Is it to save money to pay for your kids' college education? Is it to save money for a large purchase? Whatever your answers to these questions, those answers should guide how you invest your money.

Investing for retirement is different from investing (saving) for a downpayment for a house. Retirement investing will have a longer time horizon than saving for a downpayment for the home. Because of that long period, when investing for retirement, you can take on more risk in your portfolio than for shorter periods. How much risk? We'll dive into that in more detail in the next section.

Here is the main point of having a plan. It provides a roadmap. It has a target date (or time) when you want to use the money. That time will guide how you invest. It will keep you focused on the goal and not what's going in in the short term. Volatility is part of investing in securities. There's no way around it. In the previous ten plus years, we had a great run in the market. That came to an abrupt end in February and March of this year (or did it?). Look at the numbers below for confirmation of the volatility.

That is not likely to change. If anything, it will probably worsen. We're dealing with the coronavirus, which has increased fear and angst for everyone. We have an election, which adds to the fear and uncertainty. We have an economy that was effectively shut down for a few months. Indications are we are coming out of it. But it's too soon to tell for sure.

I'm assuming for this post that you have a plan. If you don't have a plan underlying why you're investing, it will be complicated for you to get through these kinds of times. Build that foundation first. Then proceed to the next steps.

2. Check Your Risk Level

Many investors, especially those who are just starting, have too much risk in their investments. I've heard many of them say something to the effect of, “Hey, I'm young. I'm in it for the long term. When it drops, I'll buy more.” And that's a great strategy – until it isn't.

Take a look at some of the recent returns:

• February 12 to March 18 -27%
• March 4 to March 11, – 12%.
• On March 12, the index fell by -9.5%. That one day drop was the largest since 1987
  (Source: Statista).

That volatility was enough to drive many individual investors out of the market entirely. Others sold large portions of their stock holdings.

Stress Test Your Portfolio

If you manage your investments, one or more of your mutual fund companies likely have portfolio analysis tools you can use. No one likes volatility when investing. Therefore, if the dislike turns into fear, it's time to make changes. Make those changes sooner rather than later.

That doesn't mean you should sell all of your stocks. That would not be prudent. What it does mean is to reduce the amount of money invested in stocks. How much? A good measuring stick would be to see how the portfolio would have performed in the crisis of 2008. As a result, when you look at that drop in dollar value, you get a sick feeling (the stomach test), lower your risk until that queasy feeling goes away.

Doing that will help you get through the next significant downturn without fear and the temptation to sell stocks at the worst possible time.

3. Make Sure Your Investments Are Diversified

I've written a lot about investment diversification. Here is how we defined it in one of those posts:

“Investment diversification means you don't want to have all your investment eggs in one basket. Having your investments spread across various asset classes (stocks, bonds, cash, real estate, etc.) helps manage risk.

Investment diversification reduces the risk of owning one asset class. Unlike the 2008 financial crisis, in most cases, investments do different things at different times. They don't all go up or down at the same time by the same percentages. And remember, you only lose money if you sell those investments during the market drops.

Diversification reduces risks. A broadly diversified global portfolio exposes investors to markets around the world and diversifies risks that have no expected return. If we want an entirely market-based globally diversified portfolio, it should include allocations in the world's markets. On average, world markets consist of 52% U.S, 36% foreign developed, and 12% in emerging markets. Most of us would not be comfortable having that much money in international stocks.”

Below is a chart of some major indexes' returns for Q2 2020, 1, 3, and 5-year.

It's a perfect example of why having money allocated among these and other asset classes are essential. We never know where the best returns will be, which brings us to point #3.

4. Asset Allocation

Asset allocation describes the amount of money you have in the various areas of the market. At its most basic, asset allocation means how much money you have in stocks, bonds, and cash. Stocks and bonds describe broad asset classes. Stocks and bonds then get broken down into sub-asset classes for greater diversification,

It might start with U. S. stocks vs. foreign stocks. Foreign stocks might get divided into developed markets and emerging markets.

Within both foreign and U. S. stocks, asset classes get broken down further by separating the companies' size (large, medium, and small) and if companies are value stocks or growth stocks. There are multiple ways to determine what makes a growth and value stock. I won't get into that here.

Here's what asset allocation looks like for a 50% portfolio in stocks and 50% in bonds (that's the broad asset class mix).

We use asset allocation to accomplish two things:

• Diversification – As we saw from the previous section, that means having money invested in different areas of the stock and bond markets. Except for real estate, we have not included another great area of diversification – alternative investments.
• Risk reduction – The second, and many would say, the most critical reason for asset allocation is to manage investment risk. With higher risk comes higher expected return. Stocks are riskier than bonds. Bonds are riskier than cash. The more money one has in stocks, the riskier their investments. In my view, investors should take only as much risk as needed to accomplish their investment goals. Anything above that is an unnecessary risk, in my opinion.

5. Control What You Can Control

Steps one through three are all things we can control. Spend time working on those things. What we can't control is what the market does, especially in the short term. Yet far too many of us spend time looking at our portfolios every day, week, or month to see how they're doing. That will drive you crazy.

It causes us to do things we shouldn't do, like sell when we see our portfolio drop. If you can't handle significant drops in value over short periods, consider these two things.

• You have too much invested in stocks.
• It would help if you weren't in stocks at all.

If risk and return are related, which they are, then if you want higher returns, you will have to accept higher risk. However, there is a limit to that risk. It would help if you only took as much risk as you're willing, able, and need to take. How do I know how much risk I need to take?

Go back to step #1 for your answer.

Final Thoughts

Crazy times don't necessarily call for crazy reactions. Reacting out of fear, panic, or desperation rarely works. Making decisions during these kinds of emotions can be and usually is damaging. However, we see too many people making hasty decisions during these difficult times.

I'm not suggesting you do nothing. It's always good to review your plans to see if you're on track; to consider, especially in times like these, whether you need to make adjustments to those plans. However, I don't want to see anyone make rash decisions about their investments because of what they see going on right now.

Review to see if you need to make adjustments. If you find it necessary based on rational analysis, by all means, make those adjustments.

I offer this five-step process as a roadmap to follow. Stay focused. Stay strong. Stay healthy. When we get to the other side of these crazy times, I'm confident you'll be glad you did.