3 Ways to Protect Your Investments From a Market Decline

The last month and a half have been challenging in the equities markets. To say the least. The US markets were down 10%. The TSX was down 8.3%  - this doesn't include the 8.5% decline from April this year. And international stock markets have been crushed - UK LSE -7.5%, French CAC -10%, German DAX -13%, Japanese Nikkei -15% and Chinese (Shanghai) markets -21%!

With that said, chances are the stocks that you own have been punished too. Regardless of how safe or good you deem the company you have invested in to be, its nearly impossible to "swim against a rapid current".

So how can you keep your head above water in these choppy markets? Here are three actions you can take today to eliminate or reduce the stock market risk in your portfolio:

1. Sell all stocks. In turn putting all of the proceeds into cash. This course of action can potentially have many unintended consequences. Namely, creating a significant taxable gain. Also this means you have divested your portfolio of stocks. Sure the market could decline further but what if you end up selling at the bottom? The capital growth potential of stocks, historically, has been what has been a major contributor to investors' net wealth over the long term. Missing out on extended years of capital appreciation can have dire financial consequences in the future.


2. Reduce exposure to stocks. If you find yourself getting nervous and obsessing over the daily performance of the markets - it's probably a sign that you don't feel comfortable with the level of risk you've taken in your investing. This option would mean reducing your exposure to stocks, and hence risk, and using the capital to re-invest into lower risk asset classes such as cash,bonds and preferred shares. Couple of advantages to this strategy:
   
   For one, you would still be able to participate in a rising market; generating capital appreciation in your portfolio. Second, by investing in cash, bonds or preferred shares, you still have the opportunity to generate a return in the form of interest or dividends. In my opinion, the easiest and most efficient way to invest in bonds and preferred shares is through the use of ETFs. What this portfolio ends up becoming is more balanced and diversified. I have written on this in a previous blog post here. A properly balanced and diversified portfolio allows you to reduce your portfolio downside risk while still earning a decent rate of return.


3. Short the stock market. Warning: This option is the riskiest strategy and may not be suitable for you. Doing this requires that you make a strategic bet against the market. By betting against the market via a shorting instrument and with the market via ownership in shares, you are left with a hedged position. Meaning the movement of the market won't impact you either way if done properly. In my opinion, the easiest way to execute this strategy is through the use of inverse ETFs. As the name implies, these ETFs move inverse to the market or industry which they are designed to track. For example; say you wanted to bet against the TSX Index. With the appropriate ETF, if the TSX was -1% for the day, the ETF would be +1%.
   
   Couple of caveats here: First, there are some ETFs that employ leverage. By doing this, they can move 2-3 times to the inverse performance of the market or industry being tracked. That is to say if the TSX was -1% some ETFs could be +2 to +3%. The use of leverage can accelerate losses should the strategy not work in your favour. Second, even though you made the right call in forecasting that the market or industry would decline by X%, the ETF may not mirror the inverse performance by being +X%. Reasons why are a bit more complicated than you probably care to get into but it involves the use of derivatives. Basically, what it comes down to is this strategy is the riskiest of the three outlined and may create additional unintended risks.

Having gone through the above list, for most investors the most appropriate strategy is likely number 2. So if you are feeling nervous about the stock market but don't want to run the risk of selling at the bottom, consider adding cash, bonds and preferred shares to your portfolio.

Want to learn more on how to do this? Feel free to contact me.