Downside Protection in an Equity PortfolioAdvice to the Advisor
“Downside risk is an estimation of a security’s potential to suffer a decline in value if the market conditions change,” is the way Investopedia.com explains what no investor wants—the chance to lose money. “In general,” Investopedia authors observe, “many investments that have a greater potential for downside risk also have an increased potential for positive rewards.”
In an interview with our Institutional editor, Managing Director Dave Gilreath explained key risk management tactics employed by the firm’s portfolio managers. In fact, Gilreath quipped, “If you don’t have low downside risk, you don’t make it to the Sheaff Brock ‘party’ in the first place,” meaning that our firm’s stock selection process begins with measuring downside risk.
- Using Revelation Investment Research data
Revelation is an independent, specialized equity research firm with the mission of providing downside risk forecasts. Gilreath explains, the Revelation study shows over a 14-year period (2002–2016), stocks rated as having the most downside risk underperform with high volatility, while stocks with the least downside risk outperform with low volatility.
- Selling covered calls
Options are generally thought to be risky, but selling covered calls can be a way to reduce risk by generating income during the holding period.
- Selecting only domestic stocks
While large U.S.-based companies carry on multinational activity, selecting home-based stocks can avoid currency risk and certain fees, still gaining exposure to revenue earned overseas.
- Avoiding stocks from industries that appear to be “overbought”
While avoiding overbought industries that are “hot” at the time can mean missing out on pockets of unusual growth—the 2015 FANG “craze” of Facebook, Apple, Netflix, Google, for example—avoiding overbought sectors can be a form of downside risk protection.
- Fundamental research
Carefully evaluating individual companies, examining the earning potential and value of each, including expenses, assets, and liabilities, can be a form of loss prevention. At Sheaff Brock, the longer the anticipated holding period, the less reliance there is on technical analysis.
In summary, Gilreath observes, beginning the research process with an evaluation of individual companies’ downside risk, and only then applying fundamental research—that’s the Sheaff Brock way!