Why downside protection is critical in your portfolio

By David Joy, Chief Market Strategist, Ameriprise Financial

Key Points

  • An investment portfolio that loses less of its value in a market decline has less ground to make up in a subsequent recovery.
  • A downside protection strategy can help you manage the risk of declines and avoid panic selling in your portfolio.
  • Work with your Ameriprise financial advisor to factor downside protection in a long-term, personalized investment strategy.

Worried investors have grown more uneasy about slowing global economic activity along with rising market volatility and heightened political uncertainty. While the U.S. economy continues to grow — and jobs along with it — questions about the possibility of recession have become more frequent.

While we are not forecasting such an outcome in the near-term, now is nevertheless an opportune time to revisit one of the primary risk-management tools for any portfolio: downside protection.

The principal behind downside protection is that a portfolio that loses less of its value in a market decline has less ground to make up in a subsequent recovery. This positions the portfolio to recover more quickly, and with a higher portfolio value to benefit more fully as asset values rise.

Simple arithmetic illustrates this concept.

  • If a $100,000 portfolio suffers a market decline of 25%, its value would fall to $75,000.
  • To get back to even, that portfolio would need to rise by 33%. A recovery of that magnitude is certainly doable in the right conditions but is still a tall order.

But what if we applied risk mitigation strategies to the same $100,000 portfolio, and it suffered an initial decline of just 15% to $85,000? To get back to even, it would require a subsequent gain of approximately 18%, far less than the 33% gain required in the first example. And the more quickly it recovers, the sooner it can begin to grow in value again. These risks are certainly amplified if the investor is in the withdrawal phase, rather than the accumulation phase, of the investment lifecycle.1

Another immediate benefit of downside protection is that it helps alleviate the risk of panic selling in the midst of a market downturn. Remaining uninvested in the eventual recovery eliminates any possibility of recapturing the lost portfolio value.

Strategies to limit downside risk in investment portfolios

One of the most effective downside risk strategies, and perhaps the most obvious and widely practiced, is asset diversification. The old adage of not putting all of one’s eggs in one basket certainly applies here. By combining different asset categories — such as stocks, bonds, cash and alternative investments that may react differently from one another during a downturn — investors may lower their portfolio volatility and reduce the extent of losses.

There are additional specific strategies to help reduce downside risk to consider as well. For example, exposure to historically defensive sectors of the equity market, such as consumer staples, utilities and real estate.

Another strategy is factor investing. With the proliferation of increasingly specialized investment vehicles that have evolved over the past few years, it is possible to target specific factors or attributes of certain asset categories that could help limit downside exposure. Examples include:

  • Funds that invest in historically low volatility stocks (relative to price)
  • High dividend-paying stocks and stocks with a history of growing their dividends
  • Stocks of companies with strong balance sheets and high-quality earnings
  • Options and structured product strategies

In the fixed-income universe, the current low-yield environment has led many investors to “reach for yield” by investing in lower-rated and less liquid bonds. While that strategy has been rewarded in what is now the longest U.S. economic expansion in history, it is showing signs of excessive risk-taking. Credit quality has deteriorated, and investor protections have eroded.

As signs of excessive risk-taking intersect with rising evidence of slowing economic activity, we believe now is a good time to consider raising the quality and liquidity profile of fixed-income exposure by emphasizing investment-grade corporate and government bonds.  

As with any investment strategy, however, not overpaying is critically important. Downside protection strategies are no secret, and many investors have already employed them in anticipation of an economic slowdown. Some strategies have arguably become overvalued relative to their longer-term history, so it pays to do your homework.

If you would like to learn more about these and other risk mitigation strategies and whether they may be appropriate for you, please contact your Ameriprise financial advisor.