The Motley Fool

How To Protect Your Portfolio From Market Downturns

I recently recovered from a bad bout of flu, and my visit to the doctor reminded me that there was something called a “flu vaccine” which I should have taken to reduce the chances of catching the flu and its associated symptoms.

This episode got me thinking about how we, as investors, should also seek to immunise our portfolios to prevent it from being impacted by rogue events which we did not anticipate. Much as we would like to think of ourselves as being prepared for whatever comes, a dose of prevention is always a better idea than seeking a cure, especially when one may encounter different sources of stress when an economic crisis hits.

So how should we immunise our portfolio, and what kind of “vaccine” is the most effective?

Makings Of A Good Vaccine

In medicine, a good vaccine is recognised as one which can cover a wide range of diseases, or at least the one which it was targeted to fight against, as well as different variants or strains of the bug.

Similarly, in investing, we want to make sure that we have in place various safeguards such that if something bad happens (i.e. the disease strikes), then the portfolio would be well-prepared to handle it.

Attributes such as strong, well-run companies with good balance sheets and good free cash flow generation are all hallmarks of a successful vaccine. Owning such companies would prevent the portfolio from going into a meltdown should an economic downturn occur. Other attributes would include reasonable valuation metrics and the presence of dividends and share buybacks conducted by management.

Injecting The Vaccine Into The Portfolio

With the criteria established for a good portfolio vaccine, we now need to “inject” it into the portfolio.

By ensuring that the companies you own have these strong characteristics, you start to strengthen the effectiveness and efficacy of the vaccine in case a major malady strikes. Admittedly, this may take time and effort as investors need to work through each investment idea to judge if it qualifies to be a good vaccine or not. Changes need to be made steadily over time as better “vaccine candidates” may be found which may replace others who are not as effective.

Testing The Effectiveness Of The Vaccine

The true test of any vaccine, unfortunately, is in actually getting the disease. Most of the newly developed medical vaccines in the world are tested by infecting lab rats and then seeing how they react to the experimental vaccine. If the inoculation works, then the creature survives.

The same goes for the portfolio – it would take a true economic downturn and crisis to “stress-test” the effectiveness of the vaccine and to see if the portfolio can survive and even thrive. The problem is that such occurrences are rare by nature (an example would be the Great Recession which was a once-in-70-years event) and so the best course of action would be to stand by the attributes mentioned above as these are what prudent investors have relied upon to survive countless prior crises.

Remember that if investors devise the right vaccine for their portfolio, they need not worry when the downturn hits as their portfolio would remain relatively unscathed.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.