Last week's 11.5% stock market plunge was very scary for some, but it's also normal. Since 1949, the market has declined 10% or more once a year, on average. It's also normal for the market to decline 15% or more about once every four years, and 20% or more once every seven years.
With the S&P 500 now down 12.6% from its recent all-time high, the bottom may very be in, but of course, it also may not. The truth is that no one really knows how market participants will react to ongoing coronavirus headlines, inevitable earnings declines at certain companies, or other unforeseeable events.
On the other hand, history has shown that it has never been a great strategy to sell into a panic. The market has fully recovered from all of its past crises, and will do so again this time. However, if you're concerned about near-term declines in your portfolio, here are three strategies you can use to reduce risk while still staying in the market.
Strategy No. 1: Upgrade the quality of your portfolio
When the entire market goes down, one strategy that could pay off big is to upgrade the quality of your portfolio. What does that mean? Basically, taking money out of "lower-quality" stocks of companies that operate in very cyclical industries, companies with high fixed costs, or companies with high levels of debt. Then buy stocks of business with favorable long-term prospects, high levels of growth, high returns on capital, and cash-rich balance sheets.
An example of a lower-quality stock may be something like Ford (F 0.08%). Not to pick on Ford specifically or its management, but as an auto manufacturer, Ford has the potential to be hit quite hard. Not only is Ford facing an evolving car industry, with the rise of Tesla (TSLA 0.38%) threatening traditional auto manufacturers, but Ford also has high fixed costs, with its manufacturing plants and unionized workforce. In addition, Ford also has a huge $155 billion in debt. Though much of that is in its Ford credit division, those loans will also suffer if a recession hits and customers can't make their car payments. In addition, the company's non-finance debt load of $15.2 billion could still be a problem if Ford is unable to sell cars this year, either because of supply chain disruption or lower demand. Ford's adjusted operating income declined from $7 billion to $6.3 billion last year, as lower auto sales dented profit margins. If 2020 ends up being a much lower-sales year, that margin could evaporate entirely.
In contrast, an example of a high-quality business would be something like Facebook (META 2.48%). Facebook has a terrific business model that requires very little capital to grow and generates a huge amount of cash. The company ended 2019 with $55 billion in cash sitting on its balance sheet after generating $20.7 billion in free cash flow last year.
Although growth is expected to slow in 2020, and any sort of economic disruption could dent Facebook's advertising revenues, Facebook is still a growth business, with monthly active people up 9% and daily active people up 11% last year across its family of apps, including Facebook, Instagram, and Whatsapp. Facebook also bought back $4.1 billion worth of stock in 2019, with another $14.9 billion available on the company's current repurchase program. Since Facebook is likely to continue buying back stock, it will reap the benefits of a temporarily lower stock price.
Investors may be hesitant to sell off lower-quality stocks that may be down severely, probably even more than high-quality stocks. However, if you have losses, you'll be able to deduct them for your tax bill next year. In addition, you'll be able to sleep better at night with a portfolio of high-quality businesses bound to come out the other side of the crisis. While stocks of lower-quality businesses may snap back more if the market turns around, if the economy starts to deteriorate further because of a coronavirus-fueled slowdown, lower-quality businesses with high debt loads may not bounce back at all.
Strategy No. 2: Hedge against risks
If you're really nervous about more violent, rapid declines but don't wish to sell your stocks, more advanced investors may want to think out using options to guard against losses. This is only a good strategy if you understand options, so if you aren't familiar, I wouldn't recommend following this plan as your first go-around. If interested in learning more about options, visit our Foolish introduction to options trading.
Specifically, the options strategy that guards against large declines is buying puts. Buying a put option gives you the right, but not the obligation, to sell 100 shares of a stock at a certain price at some point in the future. You can buy puts on individual stocks, entire indexes, or sector-specific ETFs.
For instance, say you buy an April 2020 put option on the aforementioned Facebook, with a strike price of $175 at a price of, say, $7. That means if Facebook stock falls from $192 today to $150 by the expiration date in April, you make $1,800 in profit, since the option is now worth $2,500 ($25 times 100 shares) but you paid $700 ($7 times 100 shares). However, if Facebook doesn't fall below $175, you'll lose the entire $700. And Facebook would have to fall to $168 for you to break even.
Using options to hedge can be attractive because options generally offer more protection for less capital than shorting a stock outright; however, the downside is that options can expire worthless if the stock or index never hits your target price.
In addition, option prices can fluctuate wildly in a very short amount of time. Put options made investors a lot of money last week, when stocks plummeted in a short amount of time. However, if stocks rebound, the value of your puts will diminish just as quickly. Therefore, a better time to buy puts will be on days when the market goes up or bounces back, all things being equal. Of course, whether we'll get such days remains to be seen. Unfortunately, put options are currently on the pricey side after last week's big declines.
Still, while buying a put option limits your upside, it does protect against downside over the length of the option. Therefore, if you wish to remain aggressively invested, having some put options in place is a valid strategy if you're worried about drastic short-term downturns as a result of the coronavirus.
Strategy No. 3: The best option of all
Of course, if you consider yourself a long-term investor, don't need cash in the short-term, and aren't investing with borrowed money, the best strategy of all is likely this: Nothing. After all, you've picked the stocks in your portfolio for a good reason. As long as nothing has changed with respect to your long-term view of the underlying businesses, you have nothing to worry about.
Instead, try stepping away from the computer, turning off the financial news, and going off to do something fun -- though you may want to stay away from crowded public spaces at the moment. It's very likely that investors employing this third strategy that will end up doing the best of all.