Since the March 2020 low the S&P 500 is up 99%. On average historically a 5% correction happens roughly 3 times a year or every 46 trading days. A correction of 10% or more historically happens at least once per year or roughly every 117 trading days. A correction of 15% or more happens about once every 3.5 years and a correction of greater than 20% happens every 6.3 years. We've currently gone over 200 trading days since the last correction of 5% (October 2020). Statistically we are obviously way over the average currently. So what can you do to prepare for the inevitable correction? I'd like to discuss several options to help you better prepare to weather the storm and also give you some positive things to consider when the inevitable drop occurs. To be clear, I'm not a psychic. I don't play one on TV. I'm not predicting a massive correction next week or next month. I'm only trying to provide some historical context. Just as with past returns being no guarantee of future success, past failures are no guarantee of future failures. Being prepared is always better than being unprepared so with that being said here's what you can do.
⭐Diversify⭐
So before diving into diversification first let's define the two types of risk: Systemic risk and Systematic risk
🔥 Systemic Risk:
Systemic risk represents the risk connected to the complete failure of a business, a sector, an industry, a financial institution, or the overall economy. It can also be used to describe small, specific problems, such as the security flaws for a bank account or website user information. Bigger, wider-reaching issues include a broad economic crisis sparked by a collapse in the financial system..
🔥 Systematic Risk:
The term is often used interchangeably with "market risk" and means the danger that is baked into the overall market that can't be resolved by diversifying your portfolio or holdings. Broad market risk can be caused by recessions, periods of economic weakness, wars, rising or stagnating interest rates, fluctuations in currencies or commodity prices, among other big-picture issues. While systematic risk can't be knocked out with a different asset allocation strategy, it can be managed.
Diversification is pretty simple. Holding 1 stock is riskier than holding 20. Why? Well if the one stock you're holding has some kind of major negative event that's it. You're done. It's far less likely that 20 stocks will all encounter severe negative events. Make sense? As with everything though there's a point of diminishing returns. Generally this line is drawn at around 25-30 stocks. Anything held past this point offers less and less benefit. Diversification isn't just holding different stocks, it's holding different stocks in different industries that are not correlated with one another. For example: COVID hit Retail and Energy hard. People were driving less and they were definitely not out shopping. The tech sector flourished however. So if you were holding stocks in only energy or retail you would be very bad off. Having stocks across different sectors reduces your risk of a singular event wiping you out completely. This does nothing to stop a systematic event from causing loss but it's a start.
⭐ Hedging ⭐
I'm sure you've heard of hedge funds right? Well hedging can be thought of this way: you purchase car insurance to protect you in case of an accident. If you go your entire driving career without an accident you still paid the money in to protect you and you're not getting that back. Very unlikely however that you'll go forever without needing that insurance. Hedging is very similar in that your dedicating a portion of your portfolio that will lose money when the market goes up but it will lessen your losses if it goes down. There are three main ways that you do this: options, short selling, and inverse funds. As options and short selling are a little bit more advanced and way too long for this post I'll focus on the last one.
What is an inverse fund?
"An inverse fund is an exchange traded fund (ETF) constructed by using various derivatives to profit from a decline in the value of an underlying benchmark. Investing in inverse ETFs is similar to holding various short positions." From Investopedia
Put more simply, inverse funds are designed to perform the opposite of whatever they're tracking. Example $PSQ is designed to as the NASDAQ measured by ETF $QQQ moves down -1 it will move up +1. These can also happen in multiples of 2x and 3x. So $SQQQ moves up +3 as $QQQ moves down -1. That makes these very useful during crashes. During the month of March 2020 $SQQQ went from just over $80 a share to a peak of $182 in a matter of a week. Today, however, after more than a year of recovery it trades at $8.
Using this as a hedge is essentially acknowledging that you will sacrifice some gains during the bull runs to protect yourself from a black swan event. Using this you can allocate a percentage of your portfolio to serve as insurance. Will you still lose during a crash? Yes. But depending on how high the percentage you dedicate to defense you will lose much less. There are at least 50 such inverse ETFs ranging from 1x to 3x focusing on broad indexes like the S&P or narrow sectors. It is important to understand exactly how these work, why you're using them, and exactly what to use.
Currently, as discussed in a prior post, the indexes such as the S&P continue to hit all-time highs despite the fact that stocks are declining by a more than two to one ratio. That being the case a 3x inverse fund tracking the S&P such as $SPXU isn't going to help much. It is important to know exactly which sectors are currently selling off if you want to effectively adjust your protection. Energy, for example, has become a negative sector overall specifically oil. $DRIP or $DGAZ are examples of inverse funds targeting those specific areas. Market cap is another way to more specifically target your hedging. $SDD or $SRTY specifically targets small cap stocks or $MIDZ specifically targets mid caps. To be clear, this is not a recommendation or endorsement to use any of these funds currently. I'm merely providing specific examples. You can find inverse funds targeting almost any sector. I've also found that some sectors perform better in climates where a correction is assumed to be near. $UTSL is a 3x bullish fund targeting the utilities sector ($XLU ). Because utilities are viewed as a safe haven investment they tend to do better in times of down markets.
⭐ Defined Outcome Funds ⭐
Defined outcome ETFs are funds that offer varying degrees of loss protection in exchange for capped gains. Innovator ETFs debuted the first of these funds in August 2018. They track various indexes though the use of "Flex options." Think of it as buying $SPY with a safety net. For example the innovator ETFs have three levels of protection in their funds tracking the S&P 500. The U series currently offers 30% downside protection after the first 5% in exchange for a cap of 8.12% on gains. The P series offers 15% downside protection in exchange for a 12.07% cap on gains. The B series offers 9% downside protection in exchange for an 18.3% cap on gains. These caps start on the first of the month for that series and run for a year. So if investing currently you would probably need to wait until the September series to take advantage of the full buffer from day 1.
An example of how the buffer works let's take $USEP . Let's say that during the month of September the S&P 500 drops by 8%. As the U series offers 30% protection after the first 5% of losses you would only experience 5% total loss instead of 8%. Then say the market rebounds over the next 3 months running 20%. It takes 8% to get back to the starting point leaving 12% gains but you are capping gains at 8.12% in exchange for the protection leaving you with 8.12% in gains instead of 12%. A new series starts each month though so if you have used all of your gain cap you can simply buy the series from the most recent month. That also means that if you're not paying attention you can buy into a fund already beyond the gain cap meaning you get 0% gains. You can and should always check the total buffer remaining and total cap left on the innovator website here
https://www.innovatoretfs.com/
They were the first to come out with such products and have rolled out an entire new suite of them covering almost every possible asset class but they are not the only ones with these funds. If you want to see what else is out there check here
https://www.etf.com/channels/defined-outcome-etfs
Ok so this has become kind of a long post but I wanted to leave you with some positive vibes. While markets may seem pessimistic during periods of heightened volatility, they often bounce back quickly. Despite averaging a double-digit correction per year, 31 of the last 41 calendar years have finished with positive returns. Equity returns are often strongest after a decline when investors believe that the market has overreacted to the downturn. The average 12-month return immediately following a 15% or greater decline is 55%. That’s why it often can pay to remain calm and stay the course.
So there you have it. It's important to be prepared because eventually a significant decline WILL happen. If you procrastinate in preparing or overreact once it occurs you'll pay a steep price. It's much better to know your options, have some historical perspective, and be prepared to take advantage of a decline. Hopefully this helps you get started there. If you have any questions please feel free to ask below.
*I'm not a financial advisor and this is not financial advice. Never ever ever ever listen to anyone including me without doing your own research*
#newinvest #tcardizzle #prepare #investing101 #newinvestor #hedging
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