Increased market volatility is putting your investment portfolios at greater risk of losing value. This summer’s decline in the Shanghai Composite Index wiped out $2 trillion in just over two weeks.
The markets have experienced more costly crashes. The dot-com stock market crash in early 2000 lopped off $5 trillion in company market value. The 2008 financial crisis erased 30% of global stock market value.
If you see the market begin to turn down, today you have less time to react and protect your assets in a stock market downturn since markets are losing value faster. The Chinese summer rout took place over only 17 days.
If you are among the current generation of investors who is laxer on retirement savings, then you are being encouraged to invest more aggressively in retirement savings. How do you ensure those savings are protected against the next market downturn?
Avoiding Losses in A Stock Market Crash
Use options as insurance against a market decline – Let’s say you have bought stock of Lululemon Athletic (LULU). Even if there is a recession, stressed out people will do more yoga and buy more yoga wear, you reason.
Just in case you are wrong, you buy put options on LULU, which trades around $50. A put option is the right to sell a security at a predetermined price on or before a future date. You buy a put option on LULU for $30 for January 2016. The option costs a $1 for each share and you have 100 shares.
The economy turns down and yoga enthusiasts stop buying Lululemon’s yoga gear. If the price of LULU falls below $30, you break even at $30 and your profit increases as the decline steepens. How does this work? You are exercising your put option, the right to sell the share at $30, but you can now buy the share for less.
The difference less your option fee is your profit. If, on the other hand, the price does not fall to $30, you are out $100 – the cost of your insurance policy. Options can also be bought on your ETFs, mutual funds, and other investments. The Options Industry Council provides basic and advanced option calculators to take you step-by-step through how options work.
Secure a future income stream with annuities – Annuities are popular insurance products used as part of retirement strategies that protect your savings. When annuitized at a future date, the insured product pays a regular stream of payments.
An investor may make monthly payments for a period of time or provide a lump sum payment to finance the annuity. Shop around! Some annuity providers are under scrutiny for providing kickbacks to investment advisors who sell their annuities to investors. This means XYZ is incentivised to sell you ABC annuity, whether or not it is the best product for you.
Indexed annuities may not be fully insured, similar to index-linked CDs (see below).
Place money in money market accounts – Like your standard savings account, money market accounts are insured savings accounts with features of a checking account. They have more restrictions but pay higher interest.
The initial deposit for a money market account is typically about $1,000. The major limitation is a limit on the number of monthly withdraws, which varies from 3 to 6. Options for investing in money market accounts include:
High yield money market accounts – If you are willing to make a higher deposit, you can earn higher yields. Higher interest rates may be offered for deposits over $10,000 or $100,000. Monthly fees of $10 or $15 may also be waived on higher balances. No fee accounts are also being offered.
Money market mutual funds – may provide more diversification and tax exemption when invested in municipal securities. Unlike a money market account, the funds are not insured by federal deposit insurance.
Diversify your portfolio – Portfolio diversification is still one of the best ways to protect your assets in a stock market downturn. A wide choice of index and bond funds make it easy to diversify. Greater exposure to the fixed income markets can help offset the higher volatility in stock markets. Dollar cost averaging is a way to smooth out the market ups and downs.
Instilling discipline in your investing takes out the human propensity to buy and sell securities on a whim, especially when prices are volatile. The concept is simple. You invest a predetermined dollar amount at regular intervals, often monthly. As market conditions change, the disciplined investor performs better.
The following example is courtesy of the MutualFundStore:
Dollar Cost Averaging Example
Buying $2,000 worth of shares in the first month, at $14.28 per share, would have resulted in only 140 shares – whereas in this example, using dollar-cost averaging over the course of the five-month period (during which you purchase shares at varying prices) netted you 150 shares at an average price of $13.36 per share. That’s 10 additional shares.
Source: The Mutual Fund Store
Did you actively buy and sell securities during any of the recent market pullbacks? Back-test a few investments with this dollar-cost averaging calculator and see the difference in return generated by a buy and hold strategy.
Wolf in Sheep’s Clothing?
The low-interest rate environment is encouraging some investors to go out further on the risk spectrum in search of return. To appeal to the investor’s desire to save for retirement and increase returns, more hybrid securities are being sold. Make sure the higher yield is wrapped in a safe, insured investment.
The certificate of deposit (CD) is considered a safe investment but market-linked CDs (MLCD) increasingly being pushed on investors introduce different risks. These securities may also be called equity-linked, structured or indexed CDs. The returns on these CDs are linked to the performance of a market index of stocks, bonds, currencies or other assets.
While CDs are insured (by the FDIC in the US), the principal on market-linked securities must be insured by the issuing bank. Investors may also be locked in for a longer time period, say 20 years versus around three years for a conventional CD.
Be prepared to do extra due diligence around the risk profile and insurance coverage of any new products being sold, especially when they are bundled with securities that are traditional stalwarts of safety – CDs, annuities, government bonds.
If you do invest in high yield securities, consider risk neutralized pooled funds, such as diversified exchange-traded funds (ETF).
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