How To Protect Your Portfolio From a Big Stock Market Decline

How To Protect Your Portfolio From a Big Stock Market Decline


Reader Note: From time to time this blog will post guest posts. Today I have a great post from Troy over at Market History. You can obtain more sage wisdom over at his blog.
Markets adhere to cycles because the stock market is ultimately tied to the state of the economy. Economic expansions and contractions have cycles as well. Economic expansions in the U.S. have historically lasted 5-10 years. We are currently in year 8 in this economic expansion.
I believe that this economic expansion will probably stretch past 10 years into maybe year 11 or 12 because inflation has yet to rear its ugly head. Inflation always picks up significantly before a bull market dies. But regardless of whether this expansion lasts another 2 years or 4 years, one thing is certain. We are certainly in the late stage of this economic expansion. The U.S. economy is still growing, but certain areas don’t have as much for growth as they use to (e.g. employment).
Here are some things you can do to protect your portfolio in the upcoming storm.
All cash
The best choice of action is to sell your stocks and stay in cash during a bear market. Charlie Munger – Warren Buffett’s long time investment partner – is fond of saying “some of my best investments were a result of my just sitting there and waiting for a good opportunity”. Imagine this. If you sell your stocks and then buy them back when the market falls 50%, which is normal for a bear market, you will make a 100% gain when the market reaches its old all time highs! Being in cash allows you to shop around for rock bottom prices when the opportunity presents itself. An investor who’s fully invested can do nothing more than pray to God that the market turns around ASAP.
I can understand why some people don’t want cash lying around. They’re afraid that they’ll make a wrong prediction. They’re afraid that they’ll sell and then watch the bull market continue for another few years without participating in the gains. That is a reasonable fear, especially for non-professional investors who don’t have a lot of time to study the markets. So if you just have to be invested in some assets despite being bearish, here’s what you can invest in.
Dividend stocks
Dividend stocks such as AT&T significantly outperform non-dividend or low-dividend stocks during bear markets for several reasons.
Dividend stocks tend to be large cap companies whose stock prices don’t rise that much when the market goes up and don’t fall that much when the market goes down. This is because large cap companies tend to have more stable earnings than smaller cap growth companies. For example, AT&T fell 47% in 2007-2008 while the S&P fell 57% during that same period.
The dividends will mitigate some of the capital losses. Perhaps the dividend will be cut, but usually large cap companies do not cut their dividends significantly during bear markets.
Historical data shows that dividend stocks have outperformed non-dividend stocks from 1900-present. This outperformance is especially notable during bear markets such as 2000-2003 and 2007-2009.
Sell foreign stocks and buy U.S. stocks
Investors in non-U.S. stocks should be careful. When the U.S. stock market goes down, everything is dragged down with it. And in a lot of cases foreign stocks will fall even more than U.S. stocks!
For example, the 2008 crisis originated from the U.S. while the Chinese economy was very robust. But while the S&P 500 fell 57% in 2007-2009, the Chinese stock index SEC fell 72%!!
In addition, the U.S. dollar tends to go up during bear markets because investors rush to buy this safety haven. Thus, anyone who sells foreign stocks and buys U.S. stocks has actually made a profit from this currency transaction.
The more aggressive approach
The more aggressive approach is to short extremely overvalued stocks once the bull market ends. For example, many tech stocks right now have P/E ratios of 300 or 400+, which is 20x the long term average for U.S. stocks. These stocks will crash when the next bear market comes along. (I’m looking at you, Netflix and Tesla).
If you’re going to short stocks, do so on the way down and not on the way up. By this I mean that you should not short overvalued stocks while they’re still going up. The market can stay irrational longer than you can stay solvent. If you short at $50, the market might first soar to $80, wipe out your capital, and then crash to $5. You have no idea how much further the bubble will inflate.
But once the bubble has ALREADY burst, it is much safer to short the stock. Bubbles rely on investor belief and exuberance. Once that blind belief is taken away, there is nothing left to sustain the bubble. The overvalued stock then sinks rapidly without any meaningful rallies.

6 thoughts on “How To Protect Your Portfolio From a Big Stock Market Decline

  1. Great overview Troy!!! I think with the market trending down and war on the horizon we’ll see some continued pull back in the market. Should be interesting to see what happens in the future. Either way I should be fine since I regularly dump money into the market. So up or down I have a long enough time horizon 🙂

    1. I don’t quite think a war will happen. I think Trump engaged in Syria primarily because he needed a bump in his polls, and both Democrats+Republicans could get on that bandwagon.

      In terms of North Korea, I think China has the situation pretty much contained. It’s hard for North Korea to threaten a war when their missiles don’t work!

  2. The interesting thing to see is if this is a short-term making of a bear or just a bump in the road to a longer secular bull.

  3. A well written and detailed article!Thanks for sharing such an amazing insight with us. I would like to elaborate on an important discussion here about portfolio diversification which I believe is very important in protecting your portfolio from any internal or external shocks. Portfolio diversification means deployment of your funds/resources into multiple asset class/ securities with the objective of reducing the quantum of risk and to prevent the impairment of the entire portfolio due to bad performance of a particular asset class/ securities, country or industry.Portfolio diversification is a balance between concentration and over-diversification optimize risk and potential return. A diversified portfolio may contain 70% stocks, 25% bonds and 5% short term investments. Diversification is important since it is correct for human bias, reduces volatility of your portfolio and enables rebalancing.

    1. I totally agree with you. That is why I have my index funds spread amongst classes in small-cap, mid-cap, large-cap, and some small bonds. However, I am ok with having a lot in stocks because I don’t mind a larger risk tolerance. Thanks for stopping by.

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