Learn how to protect your investments in a declining stock market with these easy to follow steps.
In March of 2020, the Dow Jones Industrial Avg fell over 37% from its all time highs. In fact, March 9th 2020 was the single worst trading session since 2008 — with both the Dow and the S&P 500 dropping over 7%, in one day!
With all the Covid-19 news, instability in the oil markets, sky-rocketing unemployment rates and general uncertainty in the global economy lately, there is a lot of concern out there that we might be at the starting point of what could be a long recession period. I’m really hoping this isn’t the case, but in the event that we have entered a long decline period in the market and things start to look worse — here are 4 things you can do to help protect your investments, during these uncertain times.
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4 Ways to Protect Your Investments
1) Rotation.
The first tactic you can use to help preserve your capital in a down market is to rotate your holdings to safer sectors that aren’t as heavily affected by the market decline. It’s important to remember that even in a down day, there are stocks or securities that are down less or even positive. In fact, in my 15 years of investing, I’ve not once seen a day in the US stock market, wherein a down day — EVERY single tradeable security was in the red — there have always been small pockets of equities here and there that were green for the day.
Now it’ll take some research on your part to identify what these safe sectors are and try to determine why they are impacted less than the rest of the market, but just speaking from my personal observations — historically, I’ve seen, that when technology and financial sectors start to decline, Gold and other commodities seem to see a bit of a rise. In addition, government bonds are generally safe options to rotate into because they usually see a very low degree of volatility compared to stocks.
Also, in our current case with the coronavirus impact — we’ve seen some rotation away from travel and hospitality stocks into more medical and biotech stocks lately. So each situation is different and it has to be taken in a case-by-case basis, but if you watch the market carefully, you should be able to notice the trend of where the allocation is shifting towards — which could give you a good idea of where a safer place for your capital might be.
2) Short Selling.
The 2nd option for combating a declining market is to short certain stocks.
First — before I go any further, I just want to give you guys a warning that shorting stocks is a very advance and fairly risky tactic in the stock market. And unless you have extensive trading knowledge or experience — I’d say that this method is probably not the safest for you to use.
But with that, let me explain a little bit about what shorting a stock means. Shorting is a trading maneuver in which you profit from the decline of a stock price. And the way it works is like this.
Let’s say you believe that the stock price of company A will drop in the near future. So you put an order in with your brokerage firm to short 1 share of company A stock. Your broker then has to go and find 1 share of company A stock to borrow for this short sale. Your broker will usually look within his entire client portfolio for that one stock, borrow it from someone for the purposes of your short sale order and then immediately sell that stock in the open market.
Let’s say Company A stock is currently selling for $200, and so your broker sells one share of this borrowed stock for $200 and credits your account with that $200. Then as the weeks go by, let’s say that your intuition was correct and the stock price drops to $160. Now, remember in a Short Order — you make a profit when the stock price drops, so in this case you are sitting on a profit of $40.
Now, you’re ready to close this position so you contact your broker and tell him to “buy to cover.” What that means is that your broker will now buy one share of Company A stock on the open market to cover for the one share that he borrowed for your short order. So using the $200 you were credited earlier when the short sale first happened, your broker buys one share of Company A stock at the current price of $160, returns the borrowed share back to his other client’s portfolio, and gives you back the difference of $40. And there you go — you’ve just made a $40 profit from the decline of a share price. (This is a bit of a complicated subject, so if you’d like to see me walk through this explanation in video form, click here.)
Now I’ve given a very simple high-level explanation of shorting here — but it’s actually a little bit more complicated than it sounds. And there are also a lot of requirements you need to have with your broker before you can do this, like having a certain minimum holding value in your account, you also need to have a margin account with them, and you can only do this with certain securities — mainly those with the high float. etc.
And the reason why it’s so risky and why I highly discourage it for new or beginning traders is because, unlike normally buying stocks, the most you can ever gain from shorting a stock is the starting value of your short order, while the loss that you can potential incur, is limitless.
You see, when you normally buy a stock, say for $50, the most that you could lose, if the stock price hits $0 — is the amount that you first invested, $50. But if the stock price rises, there is potentially no limit to how much money you could make.
On the flip side — when you short a stock, say at the same $50 price, the most you could ever make when the stock price reaches $0 is $50 because when you buy to cover, you only make the difference between your short price and the cover price, as your profit. So if you shorted at $50 and covered at $0, your profit would be $50 — and there would be no way for you to make anything more than that because a stock price could never be negative. However, if the stock price started to go up — theoretically, there would be no end to how much money you would lose.
So on this topic of shorting, I’ll leave you guys with just one story.
About 5 years ago there was a guy named Joe that decided to short a Biotech stock called KaloBios Pharmaceutical — who developed antibody based drugs to help fight off cancer. Now at that time, KBIO was in a lot of organizational and financial trouble and they had announced a week or so prior that they were planning on shutting down operations due to limited cash flow. So Joe decided that he would make a few quick bucks and put in an order to short $33k worth of KBIO stock at roughly a $2 short sale price, per share.
He completed the transaction and then went off to a meeting. When he got back, a friend of his messaged him asking if he was ok — knowing that Joe had shorted KBIO.
A little confused, Joe checked his Etrade account and to his shock, the share price of KBIO didn’t go down… it actually skyrocketed to over $16 a share — causing his account balance to be NEGATIVE $100k. You see, what had happened was — shortly after Joe executed his order, an investor group decided to buy up more than 50% of the outstanding shares of KBIO in the market and was in talks with KBIO leadership in a new direction to keep the company afloat. So with that news, the market rallied and drove the price of KBIO stock, up over 800%!
So what happened to Joe, in this case? Etrade froze his account and demanded that he pay off this massive debt that he now owes the financial firm.
So a struggling Joe turned to the internet… and to share this story as a cautionary tale to other potential short-sellers out there, Joe opened a gofundme page to share his story and ask for some support in paying off this massive $100k debt that he now owes Etrade. Now his story and gofundme campaign did meet a lot of criticism — but he did get enough kind support to raise $5,300 for his cause. Last I heard, he was planning to liquidate his and his wife’s 401Ks and working with Etrade on a payment plan to pay off his negative balance. If you’d like more information, just google Joe, KBIO, and etrade — and they’ll be more than a few articles on the subject.
So… I’m not a financial planner or anyone licensed to give professional investment advice — but if there is one caveat I’d love to leave you guys with, it’s to make sure you have done all of your research and know exactly what you are doing, especially when dabbling in things like short selling — so you don’t end up like poor Joe and his massive debt.
3) Inverse ETFs.
The next method of hedging your bet in a down market is to rotate into Inverse ETFs.
What are inverse ETFs? Inverse ETFs are exchange-traded funds that are designed to behave and perform oppositely from it’s tracking benchmark — similar to how you would profit from a short sale.
There are many inverse ETFs out there but let’s take the example of one of the more common ones — the ProShares Short S&P 500 (SH). This is an inverse ETF that is designed to behave in the opposite way as the S&P 500. So in any given day, if the S&P 500 is down 2%, then you should expect to see this Proshares Short S&P 500 ETF, up 2% and vice versa.
Now the details of how an inverse ETF works under the hood are a little too complex and time-consuming for this article, but one key thing to note here is that unlike shorting a stock, since this is a fund, in terms of your downside, it is capped at your total investment, meaning you can’t lose any more than what you’ve put in. This inherently makes it a safer option than short selling a stock.
One other interesting thing about the class of securities is that there are also things like triple leveraged inverse ETF — which means for every 1% the standard benchmark drops, the inverse ETF would rise 3% or more.
Some examples of these leveraged ETFs are SDOW (ProShares UltraProShort Dow 30), SPXS (Direxion Daily S&P 500 Bear 3x Shares), FAZ (Direxion Daily Financial Bear 3x Shares). If you’re interested in learning more about these, I’d recommend you guys go and search the “top-performing inverse ETFs in 2020” for more information.
Again — as I mentioned before with short selling, make sure you guys do thorough research and understand exactly what these inverse ETFs do before you utilize them.
4) Do Nothing.
The last tactic that you can use in a down market is to do absolutely nothing. Honestly, by far, this is the most conservative and probably the most prudent action you can take.
You see in the last 91 years, we’ve seen 4 major stock market crashes — and within 2.5 years of each instance, the market has climbed all the way back to the levels that they were at before the crash happened. One thing you gotta remember about the stock market is that in the long term, the market always goes up.
This has been true since the start of the stock market — and has remained true no matter how severe the market crashes have been in the past. So if you believe that this will continue to be true and if you don’t need to use the capital from your investment, right this very moment — then a very prudent thing might be to just wait a couple of years for the market to recover from this crisis and resume its course upward.
Now I know that 2.5 years can seem like a long time to wait, but in the grand scheme of your entire investing journey and the course of your investment growth, two years is a pretty small fraction of time. And in the meantime — knowing that the market is going to recover within the next couple of years, this would also be a great time to put new money to work — that way, you are able to buy some of your favorite companies for a discount and ride the wave upwards when the rest of the market recovers.
So that’s it for my 4 tips on how to account for a declining stock market. Hope this gives you guys some food for thought and helps you on your investing journey — especially during these uncertain times.
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The content here is strictly the opinion of Daniel’s Brew and is for entertainment purposes only. It should not be considered professional financial investment or career advice. Investing and career decisions are personal choices that each individual must make for themselves in accordance with their situation and long term plans. Daniel’s Brew will not be held liable for any outcome as a result of anyone following the opinions provided in this content.
