Investing in Uncertain Times

May 13, 2024

While numerous types of risks are associated with an investment portfolio, most investors are focused on the risk of a large stock market decline and its impact. What can be done to hedge those risks?

Less Stocks More Fixed Income?

For investors looking to lower their portfolio volatility, many more options are available today than in years past.

The first option is to lower the amount of stocks you own. This was more difficult to do when bond and cash yields were virtually zero. Today, you can get money market yields of 5% or higher. CD and Treasury Bond yields at 5% or more can also be found.

This change from yields of 1% or less a couple of years ago to yields of 5% or higher has allowed investors to reconsider how much of their portfolio they want allocated to stocks vs. bonds. Collecting a 5% yield on your bonds might be great for some investors, but what if the stock market increases 20% again?

Defined Outcome Investments

“Defined Outcome Investments” are a growing tool that allows investors to maintain exposure to equity markets while shielding their portfolios from at least a portion of the losses if the markets were to fall. These investments set parameters around the potential outcomes an investor can expect to achieve over a certain period. They are often designed to be passively managed investments that track the performance of a desired index, like the S&P 500.

These investments have been created to track various types of investments, ranging from large-cap or small-cap U.S. stocks, international stocks, or even REITs.

Protecting against potential losses in your portfolio is an attractive feature of these investments; however, “there is no free lunch.” Investors in these products typically forego the dividends that the index pays out, and the downside protection must be paid for by capping the upside growth potential.

For example, let’s consider Innovator Capital Management’s series of ETFs, one of the largest players in the space. The Innovator January S&P 500 Buffer ETF (Ticker: BJAN) is designed to last one year and to track the S&P 500 Index with a 9% buffer (which protects against the first 9% of losses, but is exposed to any incremental downside if the market were to decline further) and a 17.19% cap on the upside return.

For investors interested in more downside protection, products also exist that protect against, say, the first 15% of losses, and even others protect against more significant declines of 30%.

As you might expect, increased downside protection comes at an increased cost—a lower cap on the potential upside. So, while these investments can protect your account from losses if the market falls, the capped upside may cause your portfolio to significantly underperform if the market has a repeat of last year, where the S&P 500 increased over 26%.

Conclusion

For investors interested in lowering their stock market volatility there are several options available. With markets at historically high valuations, rebalancing the risk in your portfolio may be prudent. However, as each investor’s situation and portfolio are different, it is best to talk with your financial advisor to determine if these investments should play a larger role in your portfolio.

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