How to Protect a Stock Portfolio During a Bear Market

At a time when stocks are slipping deeper into a bear market, it can be hard (and painful) to remember that stocks have the best chance of providing investors with attractive returns over the long term. Portfolios have become riskier since the beginning of the year as bonds and stocks have fallen together. But there are ways to isolate portfolios until the turmoil subsides, according to Goldman Sachs Research.

“We’re looking for strategies that reduce risk without just investing cash — that allow you to stay invested,” says Christian Mueller-Glissmann, head of asset allocation research within portfolio strategy at Goldman Sachs. He says there are five strategies There are tools that investors can use to avoid trying to time the market and incurring losses by taking on more investment risk too early in a bear market, or missing out on profits by being late. They can be used with a range of portfolios, from balanced portfolios (a mix of stocks and bonds) to those loaded with stocks.

These strategies aim to optimize the trade-off between risk reduction and cost. A wide range of investors, from individuals to large institutions, can employ many of these tactics. “The volatility could continue,” he says. “We’re trying to keep the costs as low as possible so that you can potentially implement these strategies for a few months.”

Rise in quality. That can mean buying stocks and bonds of companies with strong balance sheets, steady earnings and dividends, or those that are less volatile. While investors have been rewarded for buying companies with high future growth potential over the last cycle, stocks with proven business models and pricing power that pay off can offer some protection in a bear market, says Mueller-Glissmann.

This idea applies to forex as well, with US currency being an example of a high quality asset. “Here, with the dollar, you have a central bank that is very aggressive against inflation, very credible and a key currency,” says Müller-Glissmann. “The dollar has already appreciated strongly, and we believe there may be more to do.”

Forex trading is a type of relative value investing — positioning for one asset to rise in price while another falls — which Mueller-Glissmann says is likely to be more important this cycle. That’s a change from the last few decades, when huge swathes of assets were swept up in a massive bull market, giving passive investing a boost. Picking individual stocks and bonds rather than buying the broad index is likely to become more valuable for investors going forward, he says.

Hedge funds offer more of a hedge. For these money managers, it was difficult to beat a long-only benchmark index last cycle when pretty much everything rallied, says Mueller-Glissmann. When growth scarcity and fears of economic stagnation hit, central banks routinely stepped in to make financing cheaper and easier, which tended to push up asset prices in all markets.

Now, with inflation rising, the opposite is happening – central banks can’t cushion the stock market when it’s falling. Today, companies like the US Federal Reserve are actively trying to tighten financial conditions, reduce wage and price increases, and rebalance the labor market. “In the last cycle, central banks were your risk managers,” says Mueller-Glissmann. “Now they are actually driving the risks via higher inflation-adjusted yields and capping the upside in some markets.”

This could give a boost to some of hedge fund’s key strategies (especially trend following). While broad hedge fund returns lagged behind a basic 60-40 portfolio of stocks and bonds after the 2008 financial crisis, according to Goldman, hedge funds surpassed the 60-40 in the early 1990s and early 2000s, particularly during bear markets, according to Sachs research. Some hedge funds are publicly listed, and some widely used exchange-traded funds are associated with these methods.

Strategies that vary a portfolio’s risk based on market volatility – known as Dynamic risk allocation – can also be an opportunity. Some ETFs have dynamic risk strategies.

“It’s a simple idea: when things are volatile, you probably want to take a little less risk,” says Müller-Glissmann. “It sends me a signal that we’re in a riskier environment and that probably means I need to hold a little less equity. This type of rule has worked remarkably well over the very long term.”

investors can Use direct hedging options their portfolios against falling prices. But this tactic becomes costly over time: negative carry, where investments cost more than they return, accumulates over longer periods of time, and prices often need to move significantly for options contracts to pay off. But market moves much larger than you would normally expect — so-called tail events — are becoming increasingly common as central banks pull away from supporting financial markets. This means options contracts could pay out more frequently.

“We’re entering a world of higher inflation where cycles could get shorter, volatility could get higher and that gives you the opportunity to generate more frequent tail events,” says Mueller-Glissmann. “Perhaps they will not be as extreme as they were during and since the global financial crisis. The likelihood or probability of an option hedge paying out is higher, but the payout could be lower – but that will still make it more useful.”

This tactic can be used in Cross Asset Strategies Also: Financial markets tend to be more correlated during a bear market in equities, and currencies and commodities in particular tend to experience larger price swings during times of higher inflation, meaning a higher likelihood of a payout on associated options assets. Call options on the US dollar (which pay if the greenback rises) have also been a useful strategy this year, as have put options on bonds (which pay if fixed income prices fall).

Here, too, the change in central bank policy can be important. It was difficult to take advantage of sharp falls in financial markets following the credit crunch as policymakers essentially halted these falls. The opposite is happening now, and that can make it more attractive to sell call options (betting that an asset’s price will go up) or buy puts (betting that an asset’s price will go down), known as collaring strategies.

“This is one of those strategies that used to be very popular,” says Müller-Glissmann. “You need to go back to old rules like volatility targeting and momentum investing. It’s essentially a step back to what worked in the past.”

“There’s kind of a renaissance in risk management, period,” he added.