During the 10-year bull market in stocks, many investors have been content to pursue a simple buy-and-hold strategy, riding the market up without taking measures to limit potential losses. Today, a growing number are very worried about the downside. “This is unlike any other time in the markets over the last several years,” said Don Dale, founder of Equity Risk Control Group, which develops portfolio risk mitigation strategies. “Bigger moves up in volatility and faster moves down…this will become more the norm," he added in a detailed story in the The Wall Street Journal.

Michael Crook, head of Americas investment strategy at UBS Global Wealth Management, agrees. “We do expect to see more volatility," he said. "We don’t want our investors to be surprised if they wake up one morning and markets are down 10% in a month." Crook said that his unit, which holds $2.4 trillion of client assets, wants to keep clients calm in big market pullbacks, and is conducting “fire drills” to prepare.

Four strategies are increasingly being employed to limit the downside by risk averse big and small investors, per the Journal, as summarized in the table below.

4 Investor Strategies For Downside Protection In Volatile Markets

  • Buying positions that mitigate the damage of a sharp market decline
  • Trading more frequently to take advantage of price swings
  • Avoiding assets vulnerable to high price volatility
  • Warning clients about the risk of a big declines in their overall portfolios

Source: The Wall Street Journal

Significance For Investors

Escalating trade tensions and other risks threaten to keep the markets volatile for a protracted period going forward, Morgan Stanley also warned in a recent detailed report, in which they find downside risks to outweigh upside potential. Meanwhile, over one-third of leading investment managers worldwide are taking out protection against a sharp drop in the markets, Bank of America Merrill Lynch reports. This is the largest percentage in the history of the monthly BofAML Global Fund Manager Survey.

A growing number of investors are putting money into exchange traded products (ETPs) whose value rises when stock market volatility is up, as measured by the CBOE Volatility Index (VIX). Given that high volatility tends to correlate with down markets, or expectations of future market declines, the VIX is often called a "fear gauge" for stocks. As a result, the flood of money into these ETPs can be taken as a sign of increased nervousness among investors. The aggregate market value of these products has reached a record $3.1 billion in thus far in May, per data from FactSet Research Systems cited by the Journal.

Trading in options linked to the VIX also is up, the same report indicates. Meanwhile, a rapidly growing number of individual investors are trading options linked to stocks and stock market indexes, seeking to profit from volatility, but often underestimating the risks, another Journal article details.

For those investors who look to reduce their downside risk while also profiting from volatility by trading more actively, a growing problem is diminishing stock market liquidity, which investment management firm Bernstein has warned is in long-term decline. As just one example, a key product used by smaller investors to speculate on broad market moves or to hedge their portfolios against declines, E-mini S&P 500 futures contracts, is now difficult to trade without moving the price significantly, per the Journal.

Looking Ahead

Among the early casualties of the renewed U.S.-China trade war are U.S. semiconductor companies, as Morgan Stanley describes in a recent detailed report. Additionally, the report believes that U.S. stocks overall are not fully pricing in the potential downside risks from the conflict. This means that investors should brace for potentially even bigger upheavals to come.