What is Downside Protection and Why Is It Important?

Downside Protection

Whether you’re buying stocks directly or invested in mutual funds or ETFs, there is one important lesson to learn: You cannot time the market. If you wait for prices to fall you’ll likely sit on the fence for a long time. That’s why in this piece we’ll talk about the benefits of downside protection and then staying invested through the ups and downs.

 

What is downside protection?

The most common pattern observed for a DIY investor to select a mutual fund/ stock/ etf is to look at the past performance. Fund houses which are at the top of the returns chart during a time period garner higher inflows as compared to other funds. Most investors fail to understand the importance of downside protection.

Downside protection essentially means employing strategies that aim to reduce the frequency and/or magnitude of capital losses, resulting from significant asset market declines. Downside protection strategies involve adjusting a portfolio’s market exposure to limit the impact of potential losses from market downturns.

Why is downside protection important?

  1. Large percentage capital losses require even larger subsequent percentage capital gains for the portfolio to recover fully. The larger the losses, the disproportionately greater the size of the percentage gains required to make up for the losses. Similarly, the longer the period over which the losses occurred, the greater the gains required and/or the longer the period over which the gains need to be made.
  2. Downside risk management is necessary to minimise exposure to systematic risk. The ideal portfolio protection strategy should be designed to provide large gains during severe market corrections and allow upside participation in positive markets, thereby creating a positive skew in the distribution of investment returns. In practice, such an outcome is extremely difficult to achieve since hedging strategies are not costless.
 
How can investors protect against downside risk?

1. Diversification – Diversification is one of the simplest ways to reduce exposure to fluctuations in investor portfolios. By diversifying into alternative assets and strategies that benefit from less correlated return sources such as inflation, illiquidity, entrepreneurial risk and manager insights, the portfolio is less sensitive to traditional return drivers such as the equity market premium and interest rate movements.

For example, Tenjin Ai strategies have Investments’ in multiple assets and have diversified defensive asset exposures to ensure there is optimum diversification.

 
2.Reducing the exposure to risk assets physically – Another way to reduce a portfolio’s downside risk exposure is to physically reduce asset allocations from more volatile assets like shares and property, to less volatile assets like cash and bonds.
 

3. Targeting specific market exposure, e.g. by exploiting behavioural biases using smart beta strategies.

 
4.Using derivative instruments to change the portfolio’s market exposure to achieve more desirable outcomes, based on short term tactical market views;
 
5.Creating custom protection to manage longer term risk more cost efficiently, such as dynamic option replication strategies.
 
It’s imperative to take into account that while financial markets have gained over the long term, there have been numerous periods of extended drawdowns and no one knows what the future will bring. Markets are unpredictable.
 
If you’re an investor concerned about building long-term wealth, you may want to consider a portfolio with built-in downside protection strategies such as Tenjin AI. That could go a long way to preserving the power of your portfolio.
 
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