The week following the debt ceiling agreement produced a decline in the stock market along with record setting volatility. The DOW closed up or down over 400 points for four straight days for the first time in the over 110 year history of the index. This led many investors scrambling for safety or paralyzed with fear. Although there is not a silver bullet to deal with volatility, there are steps investors can take to help weather volatility and set up a defensive strategy against a downturn.

 Alternative Investments

While many investors use various forms of stocks and bonds, they do not use alternative investments and strategies. Alternative investments come in the form of investments such as commodities including agriculture, energy, and precious metals. These investments can serve as a hedge against inflation as well as a hedge against market uncertainty (gold). Alternative strategies include market neutral bond and stock funds that aim to participate in market upswings, but protect against stock market downturns. They are usually in the form of merger arbitrage, long-short, or funds that attempt to isolate alpha. Investors should be careful when choosing commodity funds to make sure there are not adverse tax consequences in the form of unwanted K-1’s.

Diversify

This is your classic advice. Make sure your portfolio is diversified appropriately based on your age and risk tolerance using stocks, bonds, inflation-linked bonds, fixed accounts, and alternative investments. An appropriately diversifies portfolio limits downside risk and volatility.

Hold Cash

Retired investors and those in the accumulation stage should hold some level of cash or short-term debt instruments. With an investor who is not yet retired, enough cash should be kept so riskier assets do not need to be touched for emergencies or short-term goals. A retired investor should have enough cash and short-term investments to pay income for at least a year. This allows the retired investor to be patient with more volatile investments and more importantly, not have to take money out of stocks while they are declining

Change Systematic Withdrawals

Many retirees receive a monthly payment from their 401(k) or IRA at a mutual fund company. They choose which funds the monthly withdrawal comes from. Often this is done without much thought. As market conditions change, so should the origin of the withdrawal. Retired investors should not deplete a stock fund when the market is down. Vice Versa, an investor should consider taking distributions from stock funds as they rise. Small changes in the origin of a monthly withdrawal can lead to a larger accumulation later in life

Managing Downside Risk

What I call managing downside risk, large mutual fund companies will call market timing. I believe the two are very different. Mutual fund companies with trillions of dollars in assets under management have spent years trying to persuade investors to stay put when market conditions change. When investors move money in and out of funds, it costs large mutual fund companies money. In my opinion, market timing is consistently trying to move money in and out of asset classes to try to outperform the market. I do not believe in this philosophy and research proves that only a handful of experts can succeed over the long run. Managing downside risk includes an appropriately diversified portfolio along with changes to a more conservative investment in advance of an event that is not a surprise. Absolutely, many events happen which cannot be predicted. In this case, investors must rely on an appropriately diversified portfolio. Other events can be watched closely and changes can be made ahead of time. For example, monitoring and making changes prior to the debt ceiling deadline.

Conclusion

Using the strategies in this article will help investors deal with volatility along with a decline in equities. The purpose of the article was to re-enforce ideas that investors may already know along with suggest new approaches and ideas to apply to investment portfolios. These strategies may help you sleep a little better at night.