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Protecting for a market downturn

Lesson in Course: Market movements (beginner, 7min)

Market downturns are inevitable. How do I plan or prepare for one in advance?

Eureka!

What it's about: Some assets will perform relatively better during market declines.

Why it's important: Adding these investments will lower the overall risk of our portfolio.

Key takeaway: Defensive investments will have a beta much lower than 1.

As investors, it's handy to understand how to manage our risk and bolster our portfolio for market turbulence. An easy and accessible way to start is by familiarizing ourselves with protective or defensive assets. 

What is Protective asset ?

Investments that perform relatively better than stocks when the rest of the stock market drops

What makes an asset protective?

Defensive investments are ones that historically have been uncorrelated or negatively (or inversely) correlated with the stock market.

What is Correlation?

The relationship between two things. In investing, it usually describes the relationship between the price of two investments. A positive correlation means the prices move in the same direction, while a negative (or inverse) correlation means they move in opposite directions. Uncorrelated means there isn't a relationship.

  • Positive correlation: The asset's price rises in value when stocks go up in value
  • Negative correlation: The asset's price rises in value when stocks drop in value
  • Uncorrelated: The asset's price is not related to the stock market. For example, when stock prices are dropping, these assets could be staying the same
Negative correlated assets prices act like a see-saw

These assets also protect us from inflation. In times of higher inflation, our cash becomes less valuable over time. A $1 doesn't buy as much stuff as it used to. Thus, an investment that will generate a consistent return helps us keep our purchasing power so we can keep buying the same amount of stuff.

Examples of protective assets

Popular protective assets include bonds, gold, real estate, and other alternatives. As we look at these four asset classes, it's helpful to compare their price movements to stock market selloff in March 2020 due to the COVID pandemic.

Bonds

While bond prices are generally negatively correlated with stocks, bonds also pay steady income to the investor. For these benefits, bonds are the most popular protective asset. Note, not all bonds fit the defensive asset description. Protective bonds are those with high credit ratings, such as US treasury bonds or local municipality bonds.  Lower credit rating bonds such as corporate bonds are more correlated to stocks in times of trouble. 

Bonds are borrowing contracts created by the government or businesses

For instance, suppose the economy is heading into a recession. In that case, investors who lose confidence in a company's earning potential will also doubt if the company can make the interest payments due or return the money borrowed. As a result, the investors also sell the bonds of the company.

VGLT vs S&P 500

We can see the negative correlation during the March 2020 COVID market crash. The blue line represents the S&P500 while the green graph is $VGLT, a total bond ETF by Vanguard. As the S&P 500 lost nearly 30% of its value, the price of $VGLT steadily increased.

 

Gold

Gold and other rare commodities also serve as protective instruments. 

Engagements still happen in recessions

For example, the jewelry and electronics industry supports gold and rare metal prices during all economic cycles since gold is a great conductor used in computer chips.

GLFM vs S&P 500

$GLDM, a gold ETF by State Street Advisors, lost some value during March, similar to stocks, but recovered its value much sooner than the S&P500. 

Real estate

While considered a protective asset by some, real estate is not as reliable compared to bonds and gold. An easy way for everyone to invest in real estate is through a REIT (Real Estate Investment Trust)

What is REIT ?

A REIT (real estate investment trust) is a company that owns and, in most cases, operates income-producing real estate.

REITs represent a basket of real estate properties that we can purchase, just like a mutual fund or ETF. In many cases, a REIT may own commercial real estate. They are significantly impacted during recessions when companies shut down, and fewer surviving businesses maintain large offices. 

Real estate can include commercial or residential 

The stock market often serves as a canary in the goldmine for the residential housing markets. Trends in residential real estate tend to lag stock markets by about 12 months. So if the economy turns into a recession, home prices drop a year after stock prices drop. The loss in value affects both investors in REITs that focus on multi-family homes and property owners.

We can see the correlation in the chart above between $AMT, the largest REIT by market cap, and the S&P500. In March of 2020, the REIT lost as much value as the overall stock market. Investors in luxury real estate may have more protection since these homes are always in high demand. Unfortunately, there aren't a lot of investment options available for luxury homes.

Alternatives

Crypto enthusiasts have been making the case that digital assets or cryptocurrency can replace gold as a store of value. Specific crypto like Bitcoin is designed to have a limited total supply and be noninflationary. However, it seems bitcoin is still strongly correlated with the S&P 500 when we look at the price for BTC in March 2020. The correlation may change in the future as more countries and people start adopting crypto.

The graph above shows the correlation between the S&P500 and BTC. The periods where the line chart is above 0% mean that BTC is positively correlated with the aggregate stock markets.

The caveat

Liquidity crunches or irrational selling during extreme market panics can cause these protective assets to be ineffective. In these rare events, all assets become correlated as investors rush to convert everything into cash. 

Panicked selling is irrational

The most notable liquidity crunch was black Tuesday, leading up to the Great Depression.

Black Tuesday

Stock prices began to decline in September through early October 1929, and the collapse began on October 18: 

  1. Panic set in, and on October 24, Black Thursday, a record 12,894,650 shares were traded. 
  2. Investment companies and leading bankers attempted to stabilize the market by buying up great blocks of stock, producing a moderate rally on Friday. 
  3. On Monday, however, the storm broke anew, and the market went into free fall. 
  4. Black Monday was followed by Black Tuesday (October 29, 1929), in which stock prices collapsed completely and 16,410,030 shares were traded on the New York Stock Exchange in a single day. Investors lost billions of dollars as stock tickers ran hours behind because the machinery couldn't handle the massive trading volume.

To combat panic selling, regulators have implemented circuit breakers that freeze trading for a specified time. The break from trading gives people a chance to regain rationality and is used by exchanges worldwide.

 

Actionable ideas

While liquidity crunches occur occasionally, you shouldn't throw the baby out with the bathwater. Protective assets like bonds are great additions to your portfolios. When considering protective assets, the beta measurement is a good rule of thumb to follow. Defensive assets will have a beta far below 1, while risky investments will have a beta that's larger than 1.

Besides protective investments, it's possible to buy "insurance" for our investment value using put options. However, it's a good idea to learn about derivatives and stock options before trying to use them.

Supplementary materials

Billions of dollars were lost on Black Tuesday
Read the whole storyhttps://www.history.com/this-day-in-history/stock-market-crashes

Glossary

What is Protective asset ?

Investments that perform relatively better than stocks when the rest of the stock market drops

What is Correlation?

The relationship between two things. In investing, it usually describes the relationship between the price of two investments. A positive correlation means the prices move in the same direction, while a negative (or inverse) correlation means they move in opposite directions. Uncorrelated means there isn't a relationship.

What is REIT?

A REIT (real estate investment trust) is a company that owns, and in most cases operates, income-producing real estate.