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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?

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 makes an asset protective?

For an investment to be defensive, it is historically noncorrelated or inversely correlated with the stock market. Correlation in investing means behaving the same or going in the same direction price-wise.

When an asset is inversely correlated to the stock market, the asset price rises in value when stocks drop in value.

When an asset is noncorrelated to the stock market, the asset price is not dependent on the stock market. So, for example, when stock prices are dropping, these assets could be staying the same.

A second way these assets help is by protecting us from inflation. In times of higher inflation, our money becomes less valuable over time. Thus, an investment that will generate a return helps us not lose our purchasing power.

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 often inversely 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 protective 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. For example, 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&P500

We can see the inverse 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&P500 lost nearly 30% of its value, the price of $VGLT steadily increased.

Gold

Gold and other rare commodities also serve as protective instruments. 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.

$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

Real estate, while considered a protective asset by some, is not as reliable compared to bonds and gold. An easy way for everyone to invest in real estate is through a 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 can be purchased by a ticker just like a mutual fund or ETF. In many cases, a REIT may own commercial real estate which is largely impacted during recessions when companies shut down and fewer surviving businesses maintain large offices. 

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, if we look at the price for BTC in March, we'll see that bitcoin is still strongly correlated with the S&P500. 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. The most notable liquidity crunch was black Tuesday, leading up to the Great Depression.

Black Tuesday

Stock prices began to decline in September and early October 1929, and on October 18 the fall began. Panic set in, and on October 24, Black Thursday, a record 12,894,650 shares were traded. Investment companies and leading bankers attempted to stabilize the market by buying up great blocks of stock, producing a moderate rally on Friday. On Monday, however, the storm broke anew, and the market went into free fall. 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. Billions of dollars were lost, wiping out thousands of investors, and stock tickers ran hours behind because the machinery could not handle the tremendous volume of trading.

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, we shouldn't throw the baby out with the bathwater. Protective assets like bonds are great additions to our 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 is possible to buy insurance for our investment value via put options. We will cover these strategies when we have a better understanding of derivatives and stock options. 

Glossary

REIT

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

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