Over the past few weeks, I'm sure many ASX investors have considered how to position their portfolios for a downturn. As we'd all know, that downturn is already upon us. Including the S&P/ASX 200 Index (ASX: XJO)'s nasty 2.25% drop today thus far, the index is now down around 10.8% from its February all-time high of 8,615 points.
But exactly how does one position a portfolio for downside protection? That's what we'll be diving into today.
There are two underlying ways that one can protect one's portfolio against downside risk in the market.
Is cash king?
The first way is by holding 'defensive' asset classes outside the share market, such as government bonds and cash.
Government bonds and cash are both asset classes that provide income certainty and capital protection to investors. These assets usually don't respond to investor fear like shares do. The value of cash does not change at all, at least in the short term. Meanwhile, government bonds can often rise in value as share markets fall.
The more one allocates to cash and bonds, the less exposed their portfolios will be to downside risk on the stock market.
This might suit defensive investors like retirees who rely on their portfolios for income and can least afford to risk permanent capital loss.
However, this approach comes with a big caveat. There is a price to pay for 'safety' on the markets. Cash and bonds do not offer anything close to the long-term returns that shares do. So, if an investor is more than a few years away from retirement, using these assets instead of shares in an investing portfolio is probably not the best use of one's capital.
The second way to protect a portfolio from downside protection involves investing in shares. But only in companies that have a high-quality, resilient earnings base.
Using quality ASX shares to protect your portfolio
I'll use three of my own personal portfolio holdings to demonstrate: Telstra Group Ltd (ASX: TLS), Wesfarmers Ltd (ASX: WES) and Mastercard Inc (NYSE: MA).
All three of these stocks have, at least in my opinion, high-quality, resilient earnings bases. This doesn't mean their share prices won't go down in a market crash. Remember, those events are driven by fear, not logic. But it does mean that if there is a recession, period of high inflation or some other kind of economic malady, these companies won't see a potentially fatal drop in revenues or earnings.
If there is a recession or other economic storm, how many people will stop using their Telstra data plans or home internet connection? How many will forgo buying clothes and appliances at Kmart or pot plants at Bunnings? Or be put off from tapping their Mastercard-powered cards or phones?
I'd wager not too many. If a company's profits and earnings are resilient and continue to grow over time, its share price should remain a prudent investment over long-term horizons. As famed investor (and Warren Buffett mentor) Benjamin Graham once said, "In the short run, the market is a voting machine, but in the long run, it is a weighing machine".
Investing in these types of companies is how I protect my own portfolio from downside risk. It doesn't mean that your portfolio won't suffer a severe correction every once in a while. But it does mean that the pain will usually be short-lived.
