Can you Protect Your Portfolio From The Next Market Downturn?

So far, 2022 has been a rough year for investors in American stocks -- as well as stocks from many other countries around the world. Now that the risk side of investing is once again being reflected in the market’s returns, it makes sense to try to figure out if there are ways to protect your overall portfolio from those risks.

The short answer is yes -- there are several approaches you can take to protect your portfolio from the market’s next downturn. They do, however, come with tradeoffs attached. The key to investing successfully through a down cycle is recognizing those tradeoffs. Once you recognize and understand them, you can build a robust plan to make it through and come out on the other side in a stronger place than before.

First, recognize how important time is to your success

As 2022 has reminded all of us, stocks can go down as well as up. As a result, it’s important to have a long-term perspective for the money you have invested in stocks. It’s helpful to think at least five years in the future every time you’re considering buying or selling a stock. By keeping that longer-term future in mind, you can better separate how a company’s business is performing from how its stock is performing.

If you can focus on the business behind the stock, rather than the stock itself, it becomes much easier to make rational buy and sell decisions, no matter what the stock market happens to be doing.

In addition, one strategy for dealing with a declining market is to split the cash you want to invest in a company into three equal parts. Invest the first third once you recognize that a company looks like a good opportunity. Then, if its stock continues to fall but its underlying business is solid, invest the second third. Repeat again with the final third if its stock keeps on dropping, despite still healthy operations.

By splitting your investment into thirds like that, you have the potential to lower your per-share basis price in a falling market vs. buying all at once. That can make it easier to hold on during rough times. If the stock recovers before you have a chance to buy your second or third part, at least you have something invested at the price you originally found attractive. You can then decide whether to invest the other portions of your money at the stock’s new price or save it for your next opportunity.

Next, keep an eye on your stocks’ valuation

Shares of stock have value because they represent an ownership stake in a business. That business has value because it is expected to make money over time. The amount of money the market expects it to make over time determines just how much the business is worth. You can use that logic chain to estimate a fair value for any stock you own or are considering buying. The process to do that is known as a discounted cash flow calculation.

The math behind a discounted cash flow calculation is fairly straightforward. First, build an estimate of what you think the company will earn over time. Next, reduce (or “discount”) those future earnings by a rate of return that fairly compensates you for the risks you’re taking by investing. Finally, add up the value of those discounted earnings, and the total represents what you think the company is worth today. If its stock is priced at less than that amount, it may be a bargain worth buying more of.

The table below shows the math for a simplified company that is expected to earn $10,000 per year for 10 years, then liquidate all of its profits to its shareholders. It also assumes you as an investor want to earn a 10% annualized rate of return on your money along the way.

Table by Author.

That company is expected to generate $100,000 in profits over its lifetime, and you as an investor would be satisfied paying $61,445.67 for the business today. Say the company was publically traded and had 1,000 shares outstanding. You’d judge $61.45 as a fair price, and anything below that would look like a potential bargain to you.

This line of thinking can help you make smarter decisions during a stock market downturn. After all, if a market panic knocks a company’s stock price down to well below what it’s truly worth, it might just be time to become an aggressive buyer, no matter what the market’s sentiment may be.

Finally, diversify your holdings

The ugly truth is that even the best investors get it wrong from time to time. In addition, companies can go out of business, lose their edge, or get out-innovated by competition and lose their market position. Because of this, it is vitally important that you spread your investments out over multiple companies in different industries.

Each company should be one you are willing to own on its own merit, but by spreading your investments out like that, you’re reducing the impact that any one failure has on your overall portfolio. Think of it this way -- if all your money is tied up in one stock and that company declares bankruptcy, you just might lose your entire life savings. If, instead, your money is evenly spread out across 20 stocks and one of them declares bankruptcy, you’ve lost about 5% of your invested capital.

That second situation is much easier to come back from than the first. And that’s the key to how diversification can keep bad situations from getting worse.

Put it all together for a decent downturn strategy

Have a reasonable timeline for your stock investments. Use valuation as a tool to help you figure out when a company’s shares look cheap. Diversify your holdings to reduce the impact on your portfolio from the failure of one part of it. Put all three of those factors together, and you have a solid foundation for a strategy that can help you get through the next market downturn.

If there’s a downside to this strategy, it’s that it won’t keep you from seeing your stocks fall during that downturn. By better preparing both you and your portfolio for it, however, you increase your chances of making it through the downturn intact and ready to participate in any recovery that follows. That can make all the difference in the world when it comes to your family’s financial wellbeing.

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