How to manage your portfolio in turbulent market times?

In this article, we will describe several ways to react to the current market conditions. Without assessing in detail the current market situation, one could easily say: “There is a lot going on”. The most seasoned investors are grasping to get their head around the problems and the potential solutions. The most obvious and imminent problem is the current banking crisis and how governments, central banks and regulators are handling the crisis today and in the foreseeable future. The second theme that is still driving the markets is inflation and the actions of the central banks to curb inflation that have so far been aggressive rate hikes. Will rising interest rates make a recession inevitable? And what do the higher costs of capital mean for the profitability of companies? Also, on the geopolitical side there are tensions with the most prominent ones being the United States versus China and of course the war in Ukraine.

Assume, and I think that is a very fair assumption, that we don't know how these topics will play out in the coming months. And ‘the market’ also does not know; just look at the swings in both the bond and equity markets. If you have an investment portfolio, then the actions you take will depend on your personal assessment of the current situation and how this will unfold in the coming weeks and months (and maybe even years). To make it as understandable as possible, we will use a very simplified model of the stock market. In this model the market can move in three directions. It will either go up, down or sideways. With that in mind, some general remarks can be made that could be a starting point for how to manage your portfolio in turbulent markets.

Up

This is the first direction the (stock) market could follow. Nothing is being said about the probability of this happening. What are the considerations behind this scenario?

• You are convinced that the current market turmoil will disappear due to the swift reaction of central banks and regulators. Also, the tendency of markets to overreact will evaporate. Action:

1. You sit still and let the market do its job and that is going up over the long term. If you have cash in your account, you might even consider increasing your positions. The even more opportunistic variant of this would be buying high beta stocks (growth and technology stocks) and the more defensive approach would be buying low beta stocks (such as consumer staples and utilities). Beta describes the movement of a individual stock compared to the broader market. A beta value higher than one means that the stock will fluctuate more than the market and lower than one means it will move less than the market on average. Examples of low beta sectors are health care, consumer staples and utilities.
2. An add–on could be selling put options – high volatility, high option premium – on the shares that you would like to add to your portfolio. A short put is the potential obligation to be a buyer at the strike price of the option.

• You are bullish but not that keen to take risks. You do not feel that you want to decrease your current market exposure.
  Action:

1. If you are comfortable with your portfolio as it is, you do not need to take any action.
2. If you are not that comfortable with your portfolio, you might consider keeping the same exposure in the market but with lower beta stocks in your portfolio which means increasing exposure to health care, consumer staples, and utilities. It could also be ‘swapping’ single stocks to ETFs.

Down

The other direction the market can take is declining. This can differ in severity, but the overall market will be lower in your view. What are the considerations behind this scenario?

• You are convinced that we have not seen the worst. The current situation will get worse and lead to a selloff that could lead to an overall drawdown from the peak in 2021 of around 50% taking the S&P 500 Index to around 2,400.
  Action:

1. You will sell all your holdings and maybe even takw short position in the market. The short position can be created with inverse ETFs, short futures, by shorting a CFD index, or by buying puts (or put spreads).

• You think the market will go lower, but you do not feel comfortable with a short position in the market.
  Action:

1. You will liquidate some of your current positions and will have more cash for the coming period to take advantage of lower prices. The proceeds of your selling can be invested in US Treasury Bills (3 months), yielding around 4.5 % annually – this makes sense for a USD investor. For an EUR investor the 0-1 year government bonds in Europe have at time of writing a yield-to-maturity around 2.7% with a duration of six months (these can be bought through an ETF).
2. You can also sell your current holdings and enter a GTC (Good-Til-Cancelled) buy order at a much lower level. If this happens, you have avoided some of the decline, and you re-enter the market at a lower level.
3. You can also sell your current holdings and at the same time sell puts with a (much) lower strike price giving you the potential obligation to buy the shares back. If this materializes, you would have skipped a big part of the decline. The attractive side of this approach is that the current option premium is high, due to the uncertainty in the market.

Sideways

Maybe this is not the best description of your view. Better would be: “I really do not know where the market will go. Everything is possible from here. It can be up, down or sideways. I just do not know”. Although feeling very uncomfortable, this might be the view of most investors at this moment. The question is how to act if you do not have a strong view about what might happen in the coming weeks and months. This does not mean you have to leave the market entirely. It is more about positioning your portfolio towards the current market situation. And  answering the following questions help you to determine whether you have to take any action or not. 

• What is your investment horizon? The longer it is, the less necessary it is to take immediate action. If you have a relatively short investment horizon (less than one year), reducing your exposure by half might be a step to consider.
• What would happen if the market went down another 25%? If this scenario gives you the creeps, it would be good to at least reduce your exposure.
• Is your portfolio leveraged? If this is the case, it would mean that a falling market could really hurt you. In the worst case, your investment could even be wiped out. So, reducing your leverage is a must do.
• Does the current market have a strong negative impact on your emotional well-being? Then you could reduce your position in the market or protect your holdings via short index futures or long index puts (or put spreads).
• How well-diversified is your portfolio? If you are a hard-core stock investor, and you want to stick to that, then it is nevertheless wise to consider if you should increase diversification in your portfolio. This could be achieved by swapping single stocks with sector-ETFs for example. Or by giving more weight to low beta or value stocks instead of the high beta growth stocks. Also, large caps that pay a decent dividend are worth considering.
• If other asset classes are in scope, you might consider increasing the weight of short-term bonds (bills), which give – at time of writing - an annualized return of around 4.5%. Gold has previously done well during chaotic times so this could also be considered. Adding real estate could also be an option if you pick real estate that can raise its income in line with inflation and you have long time horizon.

Wrap up

“Investing is climbing a wall of worry”. This is always the case, but now it feels like the wall is extra steep and slippery. It is especially hard times for the investor that does not hold a very strong view on the outcome of the current situation. What makes it even harder to act, if necessary, is the fact that you know upfront that you will never do the perfect trade. If you reduce your exposure and the market goes up, you feel you have missed part of the increase. If you stay fully invested and the market tanks, you will ask yourself how on earth you could possibly have been that naïve. In other words: you will never do the perfect trade. That does not mean that you should sit still and do nothing. It all depends on your underlying view on the market, your time horizon, your risk tolerance and your overall emotional well-being. Take all of this into account and adjust your portfolio accordingly.