What To Do When It Hits The Fan

When markets fall, they seem to go down in sync. It’s one of the key insights into markets that many ordinary investors fail to spot, the correlation between markets.

Similarly, this year you’ll see the S&P 500 up 25%, and the NASDAQ up closer to 45%, and the Dow Jones Industrial Average up too.

While the amounts vary, the capital flows into these indices have supported higher prices. And when they flow out, few stocks will be able to withstand the exodus of capital fleeing markets. So what can you do?

Key Points

• When markets plunge, raising cash and allocating more to fixed income is a smart play.
• Defensive and counter-cyclicals instead of growth and higher beta stocks can limit risk further.
• To profit from downturns, put options and vol instruments can be highly lucrative.

What To Do When It Hits The Fan

As capital flows exit, the first aim is to limit losses and the way to do that is to lower exposure to risk assets, such as equities, and to build higher cash reserves. There is a reason right now that Warren Buffett’s Berkshire Hathaway has more cash on hand than just about at any other time in its history.

Next on the list is to move the portfolio composition away from heavy equity exposure to boost bond exposure. For example, the traditional 60/40 portfolio could be employed if it was heavily skewed towards stocks. That way more allocation to government and corporate bonds would offer stability and a fixed income if and when equity markets tumble.

Once the foundations of the portfolio are solid, the next step can be to look at how to invest the equity portion of the portfolio. Instead of allocating to high growth stocks, which works well during a bull market, exposure to value stocks and defensive ones makes more sense. Typical enterprises that fall into this category include healthcare and utility stocks.

Should You Buy Gold?

Counter-cyclical assets like gold work well as safe haven plays during times of turbulence. Generally, investors look to boost exposure to precious metals, like silver and platinum too. These tend to complement exposure to fixed-income government and corporate bonds too.

If you want to get a bit more sophisticated in your portfolio strategy, you can look to buy instruments connected to the volatility index also, as vol tends to spike during times of heightened fear.

Similarly, tail risk hedging can be explored through the purchase of longer term put options that benefit both when prices fall and vol rises.

How To Invest When Markets Fall

When markets fall, the most important thing is not to face them like a deer in headlights looking at equity positions drop day by day. A proactive approach can not only protect principal but actually lead to profits during this time.

Whether it’s exposure to fixed-income assets that let you sleep well at night in combination with higher cash levels. Or adding instruments that benefit from fear and vol increases, such as put options, the levers to pull are numerous.

For most, the simplest approach is to look towards a heavier weighting of defensive stocks and counter-cyclicals as a first step and from there considering more advanced approaches as outlined above using options to hedge and profit from downturns.