How to Build an All-Weather Investment Portfolio That Protects You from Market Swings

Right now, the market is experiencing a lot of ups and downs due to global tensions, the upcoming US elections, and fears of a recession. To navigate these changes successfully, investors need to plan carefully to maximize returns while minimizing risks. While aiming for higher returns is important, it’s equally essential to think about the risks involved.

The Importance of Diversification

When markets correct themselves, many investors panic and sell their stocks, locking in losses that could have been avoided. One effective strategy to protect against these risks is portfolio diversification, which can help cushion against market downturns and improve overall returns.

Even during tough times, a well-diversified portfolio can still perform decently if its losses are less severe than those of the broader market. Understanding the different types of risks is vital for creating a strong, all-weather investment portfolio. Here, we’ll discuss how to build such a portfolio.

Understanding Systematic and Unsystematic Risks

In finance, risks are usually split into two categories: systematic and unsystematic. Systematic risk affects the entire market and can be caused by changes in interest rates or global events like the 2008 financial crisis or the COVID-19 pandemic. On the other hand, unsystematic risk is specific to individual companies or industries. For example, a new regulation affecting the telecom sector would only impact those companies, not the entire market. While you can’t completely eliminate systematic risk, you can reduce unsystematic risk through smart investing.

Key Principles of Diversification

Diversification is a key investing principle that helps manage risk while maximizing potential returns. For investors in India, having a diversified portfolio is essential to handle the stock market’s inherent volatility. Understanding the risk-return tradeoff is crucial for effective portfolio management. By spreading investments across different asset classes—such as stocks, commodities, and bonds—investors can lower their exposure to risks tied to specific sectors.

For example, while stocks may perform well during a market upswing, commodities like gold often do better during uncertain times, acting as a safety net. A well-diversified portfolio usually experiences smaller losses during market declines. If one investment loses value, others might hold steady or even rise, helping to balance the overall impact. This approach minimizes losses compared to investing in just one type of asset, which may all drop in value during downturns.

Measuring Performance with the Calmar Ratio

One important but often overlooked metric in portfolio management is the Calmar Ratio. This ratio measures the annualized return compared to the maximum loss a portfolio has faced, helping assess performance in terms of risk. A higher Calmar Ratio indicates a better risk-adjusted return, meaning the portfolio can generate returns while keeping major losses in check.

Diversification is crucial for improving the Calmar Ratio, leading to lower portfolio volatility and enhancing stability during market swings.

Real-World Examples of Diversified Portfolios

For instance, the S&P BSE Midcap Index delivered a 17.2% compounded annual growth rate (CAGR) over ten years but experienced a significant drop of -40.79% during the COVID-19 pandemic. In contrast, a diversified portfolio with 60% Midcap stocks and 40% gold achieved a CAGR of 14.9% while only experiencing a -14.06% drop. By including gold, we reduced the maximum loss from -41% to -14% while maintaining a solid growth rate.

Moreover, the diversified portfolio had a Calmar Ratio of 1.00 compared to 0.42 for the MidCap-only portfolio, showing that diversification leads to lower risk and greater stability. This highlights how spreading investments can lead to more consistent returns, especially during stressful market periods like the pandemic.

Building an Optimal Portfolio

Investors can choose an optimal portfolio based on their comfort with risk. A balanced portfolio should include high-growth stocks for potential appreciation, as well as other non-correlated assets to stabilize returns during market fluctuations. Thus, diversification is key for Indian investors who want to balance risk and return in a volatile market. Additionally, focusing on the Calmar Ratio can help achieve better risk-adjusted returns and minimize losses.