Although a stock market correction can be anticipated correctly, it is important to have a planned approach to mitigate risk and maneuver your portfolio in the best possible way.
Stock markets are currently in a bull run. However, when there is a positive market sentiment and a broad-based appreciation of stock prices for a reasonable amount of time, investors tend to become complacent about hedging their portfolios. It is during such times that the risk of unexpectedly large losses can eat away unrealized profits. Mainstream advisors suggest diversification as a way to protect the downside or buying put options as an insurance policy. Here are 5 approaches which are very effective if used in the right combination:
1. Diversify on the basis of risk: Simply diversifying based on different stocks or sectors may not be enough if there is an overall downturn in equity markets. “This will not just affect your equity portfolio but also your mutual fund holdings. In hindsight, the right move in 2008 was to restructure the entire portfolio into low-risk assets. A risk-based approach to diversification is way better than spreading your eggs in different baskets using an equal weight approach,” says Tejas Khoday, Co-Founder & CEO, FYERS (A new-age discount broker with innovative trading platforms).
2. Maintain low correlation: Although most sectors are somehow correlated, investors will be more immune to tail risk if their portfolios are not heavily concentrated in complementary businesses. For instance, real estate companies, housing finance companies, and sanitary ware are somewhat related in the sense that their growth depends on the demand for housing. If there is a lull in housing demand, all these sectors will be affected simultaneously. Such exposure can be avoided by investing in sectors which can grow independently of each other. It gives you an extra protection against tail risk.
3. React early to volatility: Although a heightened volatility cannot indicate future returns, it can indicate future risk. In such times, it makes sense to restructure your portfolio in such a way that the risk-adjusted returns are better. Investors who have a static allocation to equities at all times are going to be exposed to higher risk in such times and the returns may not be justified in comparison.
4. Invest in low-beta stocks: In market downturns, low-beta stocks give the maximum downside protection. Generally, the well-known blue chip companies are better choices than mid-small cap companies in falling markets. This is because large companies can handle adversity better, can absorb higher fund flows and tend to have more stable businesses than fast-growth companies.
“Contrary to popular wisdom, a low-beta does not necessarily mean low return. On many occasions, low-beta stocks have collectively outperformed high-beta stocks on a risk adjusted basis. This means that investors can actually reduce risk and preserve return simultaneously during bearish markets. When stock prices correct a lot, market participants embrace a defensive strategy as seen after the 2008 crisis. Sectors like IT, FMCG and pharmaceuticals saw inflows and they outperformed the cyclical high-beta stocks for several years in a row,” informs Khoday.
5. Buy put options: If you have an elaborate portfolio spread across various sectors and stocks, one thing is for sure. It has a reasonably high correlation with the Nifty Index. In such times buying put options as an insurance in the near-term makes the most sense. “Restructuring a portfolio can take time and in the panic reaction of black swan events, the most effective way to hedge is to have a short-exposure equivalent to the total value of your portfolio via Nifty put options. In the alternative, you could short the index futures contracts too if you have an allergy against paying option premiums,” says Khoday.
Although a stock market correction can be anticipated correctly, it is important to have a planned approach to mitigate risk and maneuver your portfolio in the best possible way. The best approach is a combination of the above strategies which can be acted upon your own personal selection. In evolving circumstances, evolve!