Investing in any weather: protecting your portfolio from market declines

The current market scene It is characterized by greater volatility due to geopolitical tensions, American election cyclesand recession fears. To manage market-wide fluctuations, investors must strategically position themselves to generate optimal returns with lower risk. While it is important to expect higher returns, it is crucial to consider the risks involved.

During periods of market correctionsmany investors succumb to panic selling, ultimately crystallizing losses that could have been mitigated. Portfolio diversification can serve as an effective strategy to buffer systemic risks and improve risk-adjusted returns in these uncertain times.

What many don’t realize is that even during downturns, a portfolio can still perform well if its drawdown is less than the drawdown of the broader market. In today’s unpredictable financial environment, understanding and managing different types of risk is crucial to creating an all-weather portfolio. In this article, we will explore certain ways to build an all-weather portfolio.

Risk in financial markets is generally classified as systematic and unsystematic. Systematic risk It affects the entire market and is influenced by factors such as changes in interest rates or global events such as the 2008 financial crisis and the COVID-19 pandemic.

However, unsystematic risk is specific to individual companies or industries. For example, a regulatory change that affects the telecommunications sector would affect only those companies but not others. While systematic risk cannot be completely eliminated, unsystematic risk can be mitigated through effective measures. risk management.

Diversification is one of the fundamental principles of investing that helps investors manage risk while maximizing potential returns. For Indian investors, a well-diversified portfolio is crucial to deal with the inherent volatility of the stock market. A key element to understanding diversification is the risk-return relationship, which is at the heart of portfolio management. By spreading investments across uncorrelated asset classes, such as stocks, commodities, and bonds, investors can reduce their exposure to unsystematic risks. For Indian investors, one of the strategies to manage systematic risk is to create an optimal portfolio, which means combining asset classes with different risk profiles, such as stocks, commodities and bonds. The key is to include assets that are not correlated, that is, they do not move in the same direction at the same time. For example, while stocks can rise during a bull phase, commodities like gold typically perform well in times of uncertainty, offering a hedge against stock market volatility. A portfolio diversified in uncorrelated assets tends to experience smaller declines during market crashes. When one type of investment falls, others may remain stable or even increase, offsetting the overall impact. In this way, the portfolio experiences smaller losses compared to investing in just one or similar types of assets that can all fall at the same time during a recession.

One of the least discussed but very valuable metrics in portfolio management is the Calm Ratio. This index measures the annualized return on the investment relative to the maximum drawdown of the portfolio, thus evaluating the performance of the portfolio in terms of risk. a major Calm Ratio indicates better risk-adjusted performance as it reflects the portfolio’s ability to generate returns while minimizing large drawdowns.

Diversification plays a key role in improving the Calmar Ratio. This, in turn, reduces the portfolio’s volatility and improves its Calmar index, making it more resilient to market fluctuations.

Consider the following example: The first chart shows that the S&P BSE Midcap Index earned a CAGR of 17.2% over 10 years, but suffered a significant drop of -40.79% during COVID. In contrast, the second chart, with a diversified portfolio of 60% MidCap and 40% Gold, achieved a CAGR of 14.9% with a much smaller drop of -14.06%. By allocating 40% of the portfolio to gold, we managed to reduce the drawdown from -41% to -14%, while maintaining a CAGR of 14%.

Furthermore, the Calmar Ratio is higher for the diversified portfolio (1.00) compared to the pure MidCap portfolio (0.42), highlighting the reduced risk and better stability. This demonstrates how diversification can reduce volatility and provide more stable returns, particularly during times of market stress such as COVID.

An investor can select an optimal portfolio and allocate funds according to his or her risk tolerance. The following table illustrates how changes in the allocation between a risky asset (Midcaps) and a safe asset (Gold) impact the CAGR, drawdown and the Calmar index.

A balanced portfolio should include high growth stocks for capital appreciation, along with other uncorrelated asset classes to stabilize returns during periods of market volatility. Diversification is therefore crucial for Indian investors looking to balance risk and return in a volatile market environment. Additionally, investors can achieve better risk-adjusted returns by focusing on the Calmar ratio and reducing portfolio drawdowns.