Last year was a tough one for any type of investment, characterized by high volatility and negative returns, with stocks, bonds, and cash all losing money in 2022. The good news is that there are a few different ways to reduce investment volatility and still be positioned for maximizing returns.
Bonds have always been considered the cornerstone for preserving wealth during a stock market downturn but this past year bonds also lost big. Bonds often go up in value when the stock market is going down because typically the Federal Reserve is reducing interest rates to minimize an economic recession. This past year was unusual, but not unheard off, because the Fed was raising rates to induce a mild recession to fight inflation. Now that bond prices are relatively low it’s a reasonable time to include a small percentage in a portfolio to potentially profit when the Fed begins to cut rates. US treasury bonds tend to react more specifically to these rate cuts compared to corporate bonds and thus I prefer treasury bonds for this hedging strategy.
Certain sectors of the economy have less volatility than others and will often perform better in a stock market downturn, for example, the consumer staples sector. This sector comprises companies which produce products that we all need (toilet paper, dish soap, etc.) and consumers will buy them whether the economy is strong or weak. There are other low volatile sectors, but I believe consumer staples is one of the best hedges for market downturns. This sector will still go down but often by less than half of more volatile sectors and overall, it can yield good long term returns as well.
Looking at long term returns is extremely important because if you protect your investments too much from stock market volatility you will miss out on higher long-term returns. Remember that the stock market rises much more than it drops (even if it doesn’t feel that way right now) and hedging a portfolio must be done in moderation. A perfect example of a strategy that doesn’t seem to work well are Minimal Volatility ETFs. These ETFs don’t drop as much during market downturns but they also don’t rise as much during upturns, and over the past 10 years these ETFs have far underperformed the overall stock market. A more advanced strategy is using buffered ETFs that buffer how much the ETF drops but also caps how much it gains.
There are different types of investments that can be utilized to reduce volatility but there are performance tradeoffs to them all. They must be used within an overall investment strategy that specifically incorporates them in order to have a higher probability of success. One of the most common mistakes is to get overly defensive after a stock market downturn because emotionally it feels more comfortable. I’m incrementally including some of these volatility minimizing investments into portfolios with the awareness that over the next couple of years the stock market has a much higher probability of rising versus falling.
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