Hedging Your Portfolio: The Importance of Downside Protection

When preparing an asset allocation strategy for your specific objectives, it is important to not let the allure of high returns in “excess” of the benchmark lure you into a portfolio not suited for your risk tolerance. Over the course of your lifetime, your risk aversion in all aspects will continually change, but this is especially true as you near retirement.

Market corrections and declines, while unavoidable, can be mitigated through proper planning and the use of appropriate investments to reduce anxiety or stress during downturns.  These decisions will have a direct impact on your end destination as history shows equity investing over time creates more wealth. Downsizing risk does not necessarily mean sacrificing gains for safety by using traditional government or corporate bonds.  Rather it means embracing private debt that is most often more stable than public debt and far more rewarding from a yield or return perspective.

Without proper asset allocation to match the true individual comfort zone, individuals will want to do one of two things during a downturn; Either sell their investments at the worst time and create a permanent loss (instead of a temporary decline) or take on additional risks far beyond their risk tolerance.  If the second route is taken, the portfolio often experiences further decline based on gut feelings or other ill-advised strategies in an attempt to “return the portfolio to par”.   As such, instead of compounding long term wealth, you end up in a game of catch up, meaning you need to earn ever more superior rates of return to compensate for losses and return to profitability.

This brings us to the importance of proper planning and investment allocation which will alleviate this problem and ensure your portfolio is aligned both with you as an investor, but also with your end goal. This planning determines what investments will be used, and to what extent you are comfortable taking calculated risks. From a broad perspective, this is done through three primary strategies which are (1) diversification, (2) systematic allocation (or reduction) to various equity assets, and (3) strategic risk management.

Diversification and strategic allocation provide safety through a focused approach with diverse investment options in both the public and private space, and when paired with strategic risk management, it is important to capitalize on market inefficiencies, and invest accordingly. When we build your portfolio, an approach to fundamental value is taken, and the objective is to invest in fair valued or even undervalued securities to avoid “overpaying” as much as possible.

In summary, implementing a downside protection strategy linked to a client’s risk profile is important as it can enhance return potential by keeping you invested. Large sums of money can be made during a downturn by “being greedy when others are fearful” and most importantly, “not being scared out of great businesses”.  Having a suitable percentage of adequate downside protection in private or public fixed income allows us to participate in the market’s long term positive performance while also limiting the negative effects of the overall market. An extra bonus is it also provides access to money that can be used to buy into the market downturn and propel growth when equity markets eventually turn around.

Written By: Adam Prittie