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Downside Protection Strategies – Learn the Basics

Many investors set a common goal: to achieve strong returns while incurring minimal risk. However, some pay more attention towards the first part of the goal and ignore downside risk. They forget that a solid downside protection strategy is just as important as gaining high returns.

Downside protection is an essential factor to be considered in investments, especially in the risk management area. Financial advisors would recommend putting a lot of thought into minimizing the risk to protect your assets and control the potential loss from fluctuating market trends.

Here are 3 important tips to help determine the best downside protection strategy:

1. Get help from a financial consultant.

If you are planning to get your finances together, it's best to consult experts who study the field and make professional recommendations for you to maximize profits and minimize downside risk. You may search online or ask your investor friends for a reliable company focused on providing downside protection.

In turbulent markets, an average investor may pay more attention towards the gains, but not really to managing risk. If you get professionals to do the work for you, such as doing major research study of the market and monitoring market trends, it will allow you to focus more on the profit and what you can do to increase it.

A company that provides investment management services won't only provide downside protection but will also recommend alternative strategies to achieve specific investment objectives.

For example, you decide that you want to consider entering the field of real estate to diversify your investment portfolio. Employing a real estate investment firm is a great way to protect your assets if a potentially catastrophic event occurs.

Since the real estate market is uncorrelated to the stock market, fluctuations and volatility in the stock market won't directly affect your assets in real estate. And, when you invest in a real estate investment firm, they will help you make portfolio construction decisions to maximize the money you're investing.

For instance, some firms help investors build diverse client portfolios by offering them passive real estate investments that start at $5,000. These are great ways to divide your assets and minimize the risk of loss.

2. Learn the most basic strategy.

Picture this: you have $50,000, and you decide to purchase 1,000 shares of XYZ stock at $50 each. Unexpectedly, the market plummets, and your stocks are at an all-time low. Their market values fall to $25 each. Not only will you have lost $25,000, but you will also have lost the opportunity to protect capital and earn profits somewhere else.

Any good investor will seriously consider having diverse investment portfolios as one of their dominant strategies. The simplest downside protection strategy is diversification.

Tips for Effective Diversification

To do this, you should remember to spread out your money to minimize the risk of losing it all in one place. A major component of diversification is the correlation among your various investments. You should ensure that they don't trend up and down together. If they do, it means your portfolio is not exactly diverse.

Another thing you should do is diversify across asset classes. Better positioned investors allot their money to purchasing assets in equities, fixed-income investments, and real estate properties. A diverse portfolio would have at least 2 asset classes.

Diversification also involves exploring alternative investments. The macro categories under this would be Real Estate Investment Trusts (REIF), which include office buildings, shopping centers, apartment buildings, etc., and commodity investments, which include physical goods like gold, oil, and gas.

Risk Tolerance

Using diversification as a downside protection strategy entails considering your risk tolerance. Generally, the longer the timeframe, the more you can tolerate short-term losses to potentially claim long-term gains.

So, let's say you're an aggressive investor with a timeframe of 30 years or more. Because you're more flexible when it comes to time, you are more tolerant of major risks because you're thinking of potentially bright future results. In this particular approach, some aggressive investors allocate 90% of their assets to stocks and 10% to bonds.

If you're a moderate investor who's looking to claim after 20 years, you are not as tolerant as an aggressive investor because your timeframe is a little shorter. Typically, a 70-30 investment ratio applies to moderate investors.

If you're a conservative investor, you have little risk tolerance because your goals are to claim in 10 years. You don't have a lot of wiggle room to go through short-term losses. That's why most conservative investors invest 50% to stocks and 50% to bonds.

3. Plan ahead.

Protection means preventing risk before it happens. And when you're investing in something, it's best to have a fallback option in case it doesn't pan out the way you expected.

There are many reasons an investor should have a downside protection strategy in place before the unexpected occurs. Market volatility should be enough of a reason to have a protection plan and defensive strategies to secure your assets.

While it may seem like you miss out on opportunities to gain because of the strategies in place, as an investor, it's your responsibility to have an unofficial insurance policy for your assets in case they fail. It makes sense to engage and benefit from these strategies now when the cost of implementing them is low. Don't wait for catastrophic market events and high prices of loss management before thinking about protection strategies.

Striking a good balance is also important here. Your portfolio may have different aspects already, and it may be a good idea to identify which of those need the most protection. It may not be feasible to protect the entire portfolio.

Sometimes, the cost of protection may be more expensive than what you're protecting. There may also be times when the timeframe is too short that it doesn't make sense to have a downside protection strategy for it.

Lyons Fundamental Small Cap Value Strategy

Are you missing out on this market rally? Wall Street has seen a surge in small-cap stocks lately, with the Russell 2000 index climbing over 10.7% in the past month versus 5.5% gains in the S&P 500 and 6.1% uptick in the Nasdaq Composite. This rally coincides with cooling inflation data and hopes for Fed rate cuts in 2024.
We utilize our Fundamental Process, including our proprietary GRAPES valuation model, to screen the universe of mid, small and micro-cap companies, use the link below for more information.

Lyons Small Cap Value Fund >>

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