The key to effective long-term investing is protecting the capital, which followed an important rule that- ‘Never Lose Money.’
However, this doesn’t mean that one should sell their investment holdings as soon as they enter a losing zone, then one needs to remain deeply aware about their portfolio as well as the appetite of their losses in an effort to upturn their wealth. Though it is almost impossible to avoid risk completely when participating in markets, below are some of the strategies that might help to protect the portfolio.
One of the keystones of Modern Portfolio Theory is diversification. At the downturn phase of the market, a diversified portfolio will definitely outperform against the concentrated one.
Stock portfolios that consist of around 12, 15 or even 25 stocks can reduce most, of it, as that is considered as unsystematic risk, as per the various financial professionals.
Unfortunately, systematic risk is always there. But, by adding non-correlating asset classes like commodities, bonds, currencies as well as real estate to the group of stocks, the portfolio generally remains lesser volatile, also reducing systematic risk because of the fact that non-correlating assets respond inversely to the changes in the markets as compared to stocks.
Stop losses provide protection against falling prices of share. Hard stops involve triggering the sale of a stock at a fixed price that doesn’t alter.
Investing in stocks that are paying dividend is perhaps the least known technique of protecting the portfolio. Traditionally, dividends account for a noteworthy portion of the overall return of a stock. In certain cases, it might represent the whole amount. Having stocks of established companies that pay-out dividends at regular intervals are a proven technique for delivering above-average returns. Thus, when the markets are falling, the dividends serve as a cushion that makes it important to risk-averse stakeholders as well as typically results in lower volatility.
Additionally, dividends not only serve as a cushion but also are a decent hedge against inflation. Payouts remain the same.
Investors who are anxious about protecting their principal would want to study principal-protected investments with equity participation rights. Those are very similar to bonds in which principal amount is usually protected if it is been held until maturity. On the other hand, where they vary is the equity participation that occurs together with the assurance of principal.
For instance, let’s say an individual required to buy $1,000 in principal-protected investments tied to the S&P 500. These notes will get matured in 5 years. The issuer might buy zero coupon bonds that are getting matured around the same time as the notes of discount to face value. The bonds might pay no interest to maturity while they are redeemed at face value. With the help of this example, the $1,000 in zero-coupon bonds has been bought for $800, as well as the outstanding $200 is been invested in S&P 500 call options.
Every single aforementioned strategy might help in protecting the portfolio from the unavoidable volatility that occurs when investing in stocks & bonds. However, which one to opt for depends upon individual financial situations.