4 ways to manage downside risk

Investors remain on alert for volatile markets in 2024, and it’s no surprise given the ups and downs of the past few years. For example, stocks and bonds underperformed in 2022, but then we saw a sharp recovery for some stocks and a mild recovery for bonds in 2023. It’s a reminder that investing is a long-term game.

“The challenge today is that while parts of the stock market have reached all-time highs, the results overall are mixed,” says Rob Haworth, senior investment strategy director at U.S. Bank Wealth Management. “Investors should prepare for ongoing choppiness in the months to come.”

Some of this choppiness may result in downside risk. Here’s a look at what it is, what causes it and which investment tactics could mitigate it.

What is downside risk?

Downside risk is the potential for your investments to lose value in the short term.

History shows that stock and bond markets generate positive results over time, but certain events can cause markets or specific investments you hold to drop in value. Diversification can provide downside risk protection, helping you avoid significant losses and achieve your long-term financial goals.

It’s important to note that you should consider your downside risk strategy even if the market is currently stable. That way, you’ll be prepared when a downside risk event occurs.

What is a downside risk event?

It’s normal for markets to see short-term price swings due to specific events that affect investment performance. A good example of this is when the COVID-19 pandemic hit in early 2020. As schools, workplaces and stores closed, the U.S. stock market, as measured by the S&P 500 Index, lost 19.6% in the first three months of 2020. Some investors reacted to these losses by repositioning their assets in a way that hurt their long-term investment strategies, multiplying the impact of the downside risk.

Four investment tactics for downside protection

Downside protection is when you use certain investment tactics to help protect your portfolio from the negative effects of short-term market events.

Below, Haworth and Tom Hainlin, national investment strategist at U.S. Bank Wealth Management, share four tactics to help you manage downside risk.

1. Invest in high-quality bonds

As part of your diversification strategy, Haworth recommends including high-quality bonds in your portfolio.

“Making sure you own an appropriate position in high-quality, long-maturity bonds is key,” he says. “Bonds tend to provide stability to a portfolio in periods when equity markets experience volatility.”

Haworth says that bonds are particularly attractive during periods of higher interest rates. “Today’s bond market offers the potential to earn higher yields than was the case just a couple of years ago,” he says. “It makes it possible to achieve long-term investment goals while reducing portfolio risk.”

The correct bond weighting will depend on your circumstances and risk tolerance. If you’re near retirement age or have a more conservative risk profile, for example, you might want a higher allocation of bonds in your portfolio than if you still have decades before retirement.

“Sometimes people assume they don’t need to own bonds that mature in 10, 20 or 30 years,” Haworth says. “They think they only need a five-year bond portfolio. But we’ve seen that if clients only own bonds that mature sooner rather than later, when the market has down days, portfolio performance lags. Instead, we’d recommend a balanced portfolio that includes a diversified mix of shorter- and longer-term bonds.”

The bond quality matters, too. If you’ve been investing in high-yield (or junk) bonds, consider replacing most of these bonds with less-risky alternatives.

2. Consider investing in reinsurance

Put simply, reinsurance is insurance for insurance companies. That way, one company doesn’t carry all the risk.

“If an insurance company has a policy of insuring against hurricanes, for example, they’re taking on significant risk,” Hainlin explains. “They can choose to offload some of that risk to a reinsurance company.”

If you invest in reinsurance securities, your return comes from premiums insurance companies pay to reinsurance companies.

Reinsurance securities help with diversification because they revolve around events like hurricanes or other natural disasters that aren’t directly correlated with the business cycle.

Reinsurance-related securities also tend to generate competitive returns, particularly fixed-income investments that have a low level of volatility (variation in annual performance).

Source: Morningstar.

3. Go for gold

Gold is another asset that tends to be less correlated to stock market performance, meaning it’s another way to increase diversification and manage downside risk.

“We’ve seen some scenarios where gold has been a safe-haven asset when things are going poorly in the equity market,” Hainlin explains. “It doesn’t always happen, and it’s not always perfect, but if worse comes to worst, having a modest portfolio position in gold can provide protection in those environments.”

Haworth and Hainlin both stress that bonds and reinsurance tend to be more consistent in their returns (relative to risk) than gold, so consider this when developing your downside risk strategy.

4. Advanced risk-management strategies

Some investors want security beyond a shift in their asset allocations. In that case, derivatives and structured products may be an option to consider.

• Derivatives — which derive their value from an underlying asset — allow you to hedge or speculate with less capital and without purchasing the security outright. Some traders and investors use derivatives to hedge risk.
• Structured products come in many forms but often consist of multiple derivatives packaged together. Structured products provide returns based on the performance of the underlying security, without requiring a direct security purchase.

Both derivatives and structured products can help you hedge stock investments without shifting your portfolio entirely to bonds.

“If you’re worried about a potential decline in stock prices, derivatives and structured products can be a useful tactic,” Hainlin says.

It’s important to note that these types of investments are complex and generally illiquid. They also carry significant risk and may require active management. Be sure to consult your financial professional to see if derivatives and structured products are right for you.

Develop a personalized risk-management strategy

Whether you’re considering bonds, reinsurance, derivatives or other tactics to manage downside risk, it’s important to talk with a financial professional. If you’re an individual investor and manage your own portfolio, Haworth adds that you should evaluate your investments quarterly and consider annual adjustments to reflect investment performance.

Developing a long-term investment strategy that is tailored to your circumstances and goals plays an important role in mitigating downside risk. Once your investment strategy is in place, you can make tactical adjustments like the ones discussed above to address downside risk.

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