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A major dilemma for investors is to find a way to minimize the effect of economic risks, including market corrections. Nobody wants to see their portfolio make major gains, only to see those gains reduced or wiped out if there is a sharp downturn. One predominant method of trying to limit the downside capture of a portfolio is to dedicate a portion towards investments that move in the opposite direction of the market as a whole. Other risk management strategies include hedging with futures contracts, buying investments that have a low beta or even spreading out purchases to take advantages of dropping prices.
Not all drops in the stock market are necessarily a “market correction.” Corrections are large declines of at least 10%, in either an individual security, a commodity, or an index to compensate for overvaluation. Corrections are generally viewed as shorter and less problematic than actual recessions. Generally, investments should be diversified enough so that no single security instrument or commodity can sink the entire portfolio. The following strategies are more specific ways to diversify and guard against market correction.
If a number of your investments have a high degree of correlation with the market as a whole, then a correction with a major index, such as the S&P 500, the Dow Jones Industrial Average, etc., could spell trouble. By purchasing some stocks or mutual funds of stocks that belong to an industry or commodity negatively correlated with major indexes, you can see some of your portfolio appreciate in price even when the market struggles. These investments are described as “counter-cyclical.”
There are many definitions of a hedge, but the general concept is to reduce the risk of a security losing value by making a complementary investment. Counter-cyclical stocks could be considered a hedge. Purchasing real estate, gold or other alternative assets can be considered hedges. One common hedging strategy is to sell futures contracts on a stock, which state that you automatically sell your position at a certain price, avoiding stock-specific corrections.
Dollar Cost Averaging
Dollar Cost Averaging, or DCAing, is not necessarily a risk management strategy but rather a method of making long-term investment purchases in a systematic way to take advantage of short-run downturns or market corrections. Suppose you want to purchase $5,000 worth of a security and hold it for an extended period of time. Rather than making a lump sum purchase right away, you could spread out your purchases, say at $100 per month, and then be able to buy more shares if the price of the security drops. If one month, the price is $10/share, you could buy 10 shares that month. If the next month, the price was $5/share, you could purchase 20 shares. By collecting more shares this way, you aim to have a larger overall gain when the price rises again.
Low Beta Investing
Another way to protect against corrections is to simply be more risk-averse from the beginning and invest in securities that have a low beta coefficient. Your portfolio is less likely to share in market volatility with this strategy.