What a year 2018 has been! As analysts debate and discuss what caused the volatility and the downturn in the equity markets globally, you and I can agree on the shared anxiety it has created.
What would you rate as one of the most reliable safeguards against stomach-churning market volatility in the stock market? I would say diversification, both among your investments and within your share portfolio. These final days of the year might be a good time for you to take a deep breath and revisit your investment goals for 2019.
What Is Your Risk Tolerance in a Bear Market?
In investing, risk and return go together; where there is a potential return, there is also a potential loss. For example, since the end of the financial crisis of 2008, most tech stocks, such as Apple (NASDAQ:AAPL), Advanced Micro Devices (NASDAQ:AMD), Alphabet (NASDAQ:GOOG, NASDAQ:GOOGL), Amazon (NASDAQ:AMZN), Facebook (NASDAQ:FB), Netflix (NASDAQ:NFLX) and Nvidia (NASDAQ:NVDA), had been the darlings among investors. It seemed like there was no limit to how much some of these stocks could appreciate. However, the past few months have also shown investors how far and how fast these stocks can fall. These worrisome few months have been a testament to how risk and return go hand in hand.
On the other hand of the investing spectrum, many people sleep better at night if they keep a big chunk of their money at a bank they trust. The Federal Deposit Insurance Corporation (FDIC) insures deposits up to $250,000 per depositor at a given bank, yet bank savings accounts offer a relatively low annual return.
Asset allocation — which can simply be defined as how you’d divide your investments among stocks, bonds, bank-deposits, as well as other types of investment vehicles such as real estate or physical gold — determines your portfolio risk and returns. The aim is to strike the right balance between more potentially volatile assets such as stocks and more stable ones.
Constructing a Diversified Stock Portfolio That Works For You
Once you have decided how much of your wealth you would like to have in equities, it is time to look at how you want to allocate your money among different types of stocks.
How many shares should you have in your equity portfolio? The answer would partly depend on the amount you have to invest and how much time you can spare to follow your stocks. If you are not a seasoned investor, it might be better to start small; you can always increase the number of companies you hold in the long run. You may also consider adding exchange-traded funds (ETFs) to your portfolio.
Experienced investors may also consider writing covered calls on the stocks they own. Even though a covered call strategy does not necessarily provide full insurance against severe declines in a given equity (nor does it necessarily offer protection in a bear market), the option premium received helps decrease the amount of the loss. Other investors may buy put options as portfolio insurance — either on individual stocks or on an index that has a high correlation to the portfolio they need to protect. Understandably, portfolio insurance comes at a premium and investors pay to buy a put option.
Diversification will not eliminate all the risk in your equity portfolio. But your long-term risk/return ratio is likely to be more attractive. An equity portfolio constructed of different kinds of companies and sectors will, on average, yield higher returns and enable you to ride out the volatility of the stock market.
Are You in the Markets for the Long Term?
Building an all-season portfolio to weather the choppiness in the markets does not have to be difficult! Many successful investors believe in holding stocks for the long term. Well-performing stocks tend to keep on winning; therefore, a fall in their share price during a market downturn might give you the opportunity to buy more into those shares as long as you still believe in the fundamental story of those companies.