What Can I Do to Protect My Investments From a Market Downturn?

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How to Protect Your Investments in a Downturn
Are you worried the market may be poised for a fall? If so, you can implement some strategies now that can protect your investments from a market downturn. In a bear market, there are no perfect solutions, but there’s plenty you can do to minimize the damage. Here are seven of those strategies: Table of…

Are you worried the market may be poised for a fall? If so, you can implement some strategies now that can protect your investments from a market downturn. In a bear market, there are no perfect solutions, but there’s plenty you can do to minimize the damage.

Here are seven of those strategies:

1. Close Out Any Margin Positions You Have

The purpose of buying stock on margin is to double your potential profits on the upside. Buying on margin is one form of leverage (which is not limited to stocks). When you buy on margin, you borrow money from the stock broker to purchase as much as double the amount of stock.

Here’s how it works. First off, picture a theoretical stock purchase without margin. Let’s say you purchase $5,000 worth of a stock and it doubles in a year. You’ll then have $10,000, which is a 100% gain on your money.

But if you purchase $5,000 worth of stock — and double your purchase with $5,000 in stock on margin — your investment will grow to $20,000, which represents a 300% gain on your original investment of $5,000 (less interest paid on the margin amount).

But the reverse is true in declining markets. In fact, the effect is even more dramatic.

If you purchase $10,000 worth of stock with $5,000 in cash and $5,000 on margin, and the stock declines by 25%, you’ll experience a 50% decline in your actual investment. That is, your $5,000 in cash invested will fall to $2,500. That’s a 50% loss.

If you think the stock market has reached a peak, now is the time to close out margin positions to protect your investments from a downturn.

2. Start Selling Off Losers Now

If you’re holding funds or individual stocks that have performed poorly in the bull market of the past 1o years, there’s a very good chance they’ll do even worse in a general market slide. Now might be an excellent time to sell off those positions. Not only will you avoid further declines, but you’ll also free up cash for future investments (see below).

There may be a few exceptions to the rule, if either a stock or its sector tend to be countercyclical to the general market. This would be a very short list, however.

There’s some belief that gold funds tend to rise in bear markets, but that seems to depend mostly on the factors driving the decline. For example, if the cause is rising inflation, then gold funds might do well. But if the general market is caving in due to rising interest rates, gold could end up being a big loser.

3. Stop Pouring Money Into More Stocks

Other than selling off losers, you don’t have to abandon your stock positions entirely. Remember: No one can predict bear markets any more than they can predict bull markets. If you sell off most or all of your stocks — and the market continues to rise — you’ll be losing money before a downturn even gets in gear.

Also, you never want to be entirely out of stocks. The market could decline by 20% and then rise another 30% shortly after. You always want to be in a position to take advantage of that possibility.

However, if you feel that stocks are near a peak, it’s probably best to stop pouring fresh money into more stocks. You don’t have to sell off large amounts of your current stock holdings, but you can simply begin accumulating cash that will be directed into other investments as events unfold. This will help you protect your investments from a downturn

4. Shift to Dividend-Paying Stocks

If your losing positions are in growth stocks, consider shifting the proceeds from the sale of these securities into dividend-paying stocks.

There’s some evidence that dividend-paying stocks perform better than growth stocks in bear markets, though it’s not entirely conclusive. Even if that isn’t the case, dividend-paying stocks will provide you with an income on your equity holdings even during the market decline. It will be much easier to survive falling stock prices if they’re at least generating a cash flow.

The other factor is that other investors are also likely to seek out income-generating assets in a bear market. That will help to minimize the losses that your stocks incur.

And not coincidentally, dividend-paying stocks are some of the first equities that investors return to at the end of bear markets. That will leave you pre-positioned to ride the elevator up when the next bull market begins to develop.

Just make sure that the dividend-paying stocks are issued by companies with strong records of growth and profits. They should also be companies that have been paying dividends for a very long time and have shown a pattern of increasing the payout even during bear markets.

The Dividend Aristocrats are a list of stocks that have increased their dividends annually for at least 25 consecutive years. They’re a great place to start if you want to protect your investments from a downturn.

5. Invest Beyond Stocks

Unfortunately, it often seems that when the stock market turns down, it drags other markets down with it. While that may be true, other markets may not be hurt as much. For that reason, you might want to take a serious look at other assets.

One that could offer resistance are real estate investment trusts (REITs). At times, real estate has run counter to the stock market (the 1970s are an example). In addition, REITs tend to pay very high dividends. Even if the value of the underlying trust doesn’t rise in a bear market, the dividends can provide a comfortable income cushion that will offset losses in your other equity holdings.

Commodity stocks might be another consideration. Although gold funds don’t always run countercyclical to stocks, there are some economic conditions in which they perform particularly well. Rising inflation is one example. But another is political instability. A revolution or a shooting war in a major region of the world could generate the type of instability that leads to panic. And if gold loves anything, it’s panic.

Energy might be another play. During times of instability, when energy supplies become less certain, oil prices can rise dramatically. When they do, they carry energy stocks up with them.

Both gold and energy represent speculative investments, but it’s also true that they often run counter to the general equity markets. For that reason, a small position in each sector could be well advised.

6. Build Up Cash to Be Ready for Bargain-Hunting Opportunities

As you continue to fund your investment portfolio, and as you sell off losing positions, you should begin to build up a larger position in cash. This is probably the single most important bear market strategy you can have.

There are two reasons why this is true:

  1. Cash maintains its value. It may not rise, but it represents a truly safe asset. The more cash that you hold in your portfolio, the less exposure you have to potentially declining assets.
  2. You’ll be building up money to have available to buy stocks at bargain levels as the bear market rolls on and the next bull market takes hold.

The second point is particularly important. There’s often little you can do to avoid losing at least some money in your portfolio during the market decline. But you can more than make up for the losses by investing in battered stocks after the bear market. The gains that you’ll reap when you ride the market up from the bottom have the potential to offset the losses on the stocks that you held on the way down.

The more cash you have available at the market bottom, the greater your potential rebound profits will be.

7. Keep Bonds on the Short Side

There’s a common misconception that bonds run counter to stocks. But in recent years, the two have moved in concert. That’s because lower or declining interest rates fuel a bull market in both stocks and bonds. But should interest rates rise, that will not only cause the stock market to fall, but also the bond market.

You can largely avoid this problem by investing in bonds that have maturity dates of five years or less. For example, you can invest in one-year US Treasury bills or five-year US Treasury notes. You can also invest in longer-term bonds that are within five years of maturity. There are even mutual funds that invest strictly in these kinds of bonds.

The problem is that longer-term bonds tend to behave more like stocks. For example, a 30-year Treasury bond moves in inverse proportion to interest rates. In that way, a 33% increase in interest on a 30-year bond, from 3% to 4%, could cause the bond to decline by something approaching 33% of its value as bond prices fall to reflect lower rates. That won’t help you in a stock market decline.

The shorter the maturity on a bond, the safer it is as a store of value. At the top of the food chain here are US Treasury bills, money market funds, and certificates of deposit. All act more like cash than stocks and long-term bonds.

The Bottom Line

If you think a downturn is coming, pre-position your portfolio for the change and begin adjusting your investing activities accordingly. While you probably won’t be able to completely avoid losses in your portfolio, you can minimize them and protect your investments in case of a downturn. And that’s what it’s all about.

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About Kevin Mercadante

Kevin Mercadante is professional personal finance blogger, and the owner of his own personal finance blog, OutOfYourRut.com. He has backgrounds in both accounting and the mortgage industry. He lives in Atlanta with his wife and two teenage kids and can be followed on Twitter at @OutOfYourRut.

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