How can I protect my portfolio against large market downturns?

This is one of the questions I’m asked most often by clients. And I’m always frank with my answer: We can never eliminate downturns, risk or volatility. If you’re going to play the game, you have to be able to accept that there will be wins and losses. But, there is good news: We can apply proven principles that are designed to further the goals of today’s investor, aiming to increase returns, minimize downside risk and reduce volatility.

So, why then isn’t everyone walking around with a new found sense of investment peace of mind? Why isn’t everyone confident in their retirement nest egg?

Because many people – advisors and investors alike – still don’t truly understand the critical factors that impact your financial success. Much less how to build an investment strategy that adequately overcomes them.

Risk and Volatility: What’s the difference?

First, it’s essential to understand the role that both risk and volatility play in your investing success. Repeatedly, I see a large disconnect between the investor’s interpretation of what these things mean compared to what they really mean.

At its core, risk means the probability that your investment will lose money. However, I see investors routinely take unnecessary risk with their portfolio. They’ve been taught that greater risk means greater returns. This is the disconnect. Risk isn’t a knob you crank up to spit out a higher return. Cranking up the risk-o-meter only means that you have a greater chance of losing money, it doesn’t do much of anything in driving your returns.

Volatility – or standard deviation – is a measure of risk, and refers to the amount of fluctuation your investment returns may see. If your investment experiences increased volatility, its returns become more unstable. This diminishes your compound return, especially in comparison to the average return.

If an investment’s returns are erratic (they fluctuate up and down regularly), this means that the investment probably has a high degree of volatility. In essence, volatility has a direct impact on your returns.

It’s ironic, isn’t it? That risk – the one thing we can control when investing – has little to no impact on returns, while volatility – the one thing out of our control – has a large impact on your returns.

So, how can I protect my portfolio against large market downturns, you ask?

Investment Strategies Built for Modern Investors

It was in the middle of last year that I had an awakening, an epiphany you could say. One that opened my eye to the fact that even our firm didn’t have the best solutions for how to help our clients protect their portfolio against market downturns. Sure, we stuck to the traditional principles that have propelled investing academia to where it is today. We built well-diversified, adequately allocated portfolios. We determined our clients’ true risk tolerance, and invested them accordingly. We prided ourselves on helping our clients build a disciplined, sound approach to investing.

If we were doing everything “right,” giving our clients that best possible investment solutions, then why was anxiety over the market still running rampant among our client base? Why were they still feeling the sharp pains of market fluctuations?

It was in this moment that I looked up, and saw our slogan on our conference room windows: Making money work for people. Our mission statement echoed in my head: Educate, guide and counsel people to reach their full financial potential. These are our promises to our clients, our promises to the world. And our investment solutions weren’t living up to them.

With the help of new and improved research, we found the simple answer to our clients’ investing limitations: Traditional investment theories are incomplete.

So, we decided to do something about it.

Maximize Your Investing Success

To help our clients maximize their investment success and protect their portfolios against market downturns, we had to acknowledge the disconnect between traditional theories and today’s investors, the gaps that exist when comparing reality versus theory.

Our new momentum strategies are designed to fill in these gaps. While we kept a handful of traditional elements in place, we expanded upon them to include practical application for the real investor before and during retirement:

Avoid large declines. Period. As we said before, we can’t eliminate downturns, risk or volatility. Our momentum strategies are not designed to avoid declines; they can and do move with the market most of the time. However, they are designed to minimize the impact of volatility and avoid the large declines. The steep declines have the most potential for irreparable damage to your wealth.

Markets aren’t always priced efficiently and investors can be irrational. In a perfect world, investors wouldn’t take risks with their money or make emotionally charged financial decisions. Then we just might have a market that is priced efficiently 100% of the time. Unfortunately, we have irrational and risk-seeking investors, and large market participants who can influence prices. This means that stock prices can be bought and sold both at undervalued and inflated prices.

Fama & French were on to something. The 3-Factor Model created by the Nobel Prize-winning economist Eugene Fama is still used today to describe stock returns. In 2015, they extended the model to include five factors. They also discovered a persistent anomaly in the market – momentum –  which we believe to be the sixth factor. So, we designed our momentum strategies using all six factors.

Asset allocation matters. Remember, there is still something to be said about a portfolio that is well-diversified. Asset allocation accounts for 90% of portfolio returns. Investing isn’t just about choosing where to put your money, but choosing the right combination of stocks and bonds to help balance your risk to return ratio.

Understanding how the factors discussed here impact your investing success before and during retirement is only the first step. You then need an investment strategy that can truly overcome them.