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Understanding and avoiding downside loss

Understanding and avoiding downside loss

| January 20, 2021

and how to minimize it

Downside loss is an unglamorous, but crucial, side of investing to consider when assessing for risk in your portfolio. When the stock market rallies, investors are happy and believe they’ve made money. People tend only to compare which investments are better performers over a year. But what some investors don’t consider is that there may be assets in their portfolio that are just catching up with their previous losses.

For example, let’s say you have two securities, Fund A and Fund B. In 2020, Fund A performed +27% and Fund B returned +8%. Some investors would pick Fund A as the better performer. But when you look more closely, you see that the year before Fund A actually returned -67% while Fund B returned -2%. That means if you invested $100,000 in Fund A you would have $41,910 at the end of the second year. If you invested $100,000 in Fund B you would have $105,840 by the end of the second year. That’s a significant difference.

Establishing downside loss protection is critical in your investments because you have to earn even more to make up for that loss.

What is downside protection?

Downside protection is a risk-management strategy where an investor can look at different risk metrics to help mitigate loss in a portfolio. There are many ways to help prevent downside—including options, variable annuities and asset allocation. Other methods include using stop losses or buying assets that negatively offset the asset you’re trying to protect. 

Think of downside protection like insurance for your portfolio. In the case of a put option, you’ll pay a premium to the put writer as a guarantee that you can sell the stock at a strike price. It’s similar to buying a home insurance: you pay a premium to the insurance company, and if your home is damaged, or loses values, the insurance company pays you money to make your asset whole. In the case of a put option, if your stock goes below the strike price, the put writer will pay the difference if you decide to sell, so you limit your losses.

Why should you consider downside protection?

Downside protection limits your portfolio’s exposure to potential market downturns. Investors underestimate the amount of gain they’ll need to recover from a big investment loss. For example, say your stock falls 50%. How much will it take to recoup your loss? Most people would say 50%, but let’s walk through that: If you bought a stock at $10 and it loses 50%, it’s now at $5; to recover 50% of that only brings your stock back up to $7.50. Your stock actually needs to gain 100%, twice of what it lost, to get you back to $10. Here’s the cold reality of returning to breakeven:

You can help ease the pain of this loss by using downside protection strategies, especially if you have a shorter amount of time in which to recoup your loss, such as when you’re close to retirement.

How do I know if I need downside loss protection? 

All types of investors should consider downside loss protection, but the cost of downside protection needs to be assessed against how important your investment is, and when you plan to sell it. Consider each of these questions:

  • What’s your required rate of return? What level of risk are you comfortable with?
  • How involved are you in the decision-making of your investments? What’s the framework for that process?
  • What are the limits of your investment resources and experience?
  • What’s your timeframe? When do you need to pursue your financial objectives?
  • What’s the market outlook?
  • How much protection can you afford, if any? What are the consequences of incurring capital loss?
  • What types of strategies are allowed in your investment guidelines?

If you’re new to the idea of downside loss protection or want to implement a strategy that’s right for you, contact us to talk about your investment needs.

All investing involves risk, including the possible loss of principal. There is no assurance that any investment strategy will be successful.

Brentwood Financial Advisors is seasoned in complex wealth management needs. We have decades of collective experience and knowledge that you should use to your best advantage. CONTACT US to schedule a review with one of our financial professionals today to discuss your financial goals.