10 Strategies for Managing Financial Risk in Market Downturns

1. Risk Tolerance

One of a financial adviser’s first steps when meeting with a client should be to assess the client’s tolerance for risk. This is essentially a behavioral assessment of how comfortable the investor will be seeing their portfolio fluctuate in value.

If a client can’t stomach drops when the market crashes, then they may make rash decisions counter to their long-term strategy, which can have a devastating impact.

Strategy to consider: Spend the time upfront to clearly define your comfort level with market fluctuations. Discuss various market scenarios, using real dollar amounts instead of percentages, to get a feel for how different market conditions may play out within your portfolio.

2. Risk Capacity

A person’s capacity for taking risk is equally as important as risk tolerance, though discussed less frequently. An investor with high risk tolerance may want to be aggressive with their investments. However, if they don’t have capacity to take that risk, either through time horizon or financial resources, then utilizing an aggressive strategy may be imprudent.

For example, it would be ill-advised for a retired client with only a modest nest egg to invest all their funds in equities or illiquid real estate deals. If things go south, this client will have a difficult time recouping their losses. Conversely, a young investor with a high income may be fine adopting an aggressive strategy. It will position them for higher returns than a more conservative portfolio, and if their portfolio drops, they have the time and resources to wait out the downturn.

Strategy to consider: This is about numbers. Determine how long you plan to continue working, your earnings, earnings potential and amount in your emergency fund. If all these categories look favorable, you may be able to take on more risk.

3. Shallow Risk

This is the temporary drop in an investment’s market price. It happens daily in the stock market. One stock or mutual fund may have gone up in price, while another may have dropped. While this risk can hurt, since prices can drop by a large percentage and stay low for an extended period, it is not permanent.

Strategy to consider: This risk is inevitable. Anyone invested in liquid securities will experience this type of fluctuation. Maintaining a sufficient cash cushion in their checking account will allow investors to ride out any temporary drop in their portfolio.

4. Deep Risk

"Deep risk" is a real loss of capital that you likely will not recover. Financial writer Dr. William Bernstein describes this as the result of inflation, deflation, confiscation and devastation.

Devastation can be the loss of assets due to war. Confiscation can be due to an increase in taxation, or if the government were to seize your assets. Deflation is the drop in the value of assets, as seen in Japan. Finally, inflation, which is at a 40-year high, is the loss in your purchasing power as goods and services increase in price.

Strategy to consider: While all are scary to think about, inflation is the only real concern for most U.S.-based investors. Deflation can be mitigated by the Federal Reserve propping up the markets. Confiscation and devastation are less likely in the U.S. Despite criticism that can be levied on our government, it is a fairly stable system. Inflation, however, is something we are all dealing with now. Overweighting a diversified portfolio in equities, which have historically outpaced inflation over the long term, could help mitigate inflation risk.

5. Concentration Risk

This is the risk of loss when all your funds are allocated in too few investments. This may occur organically for an investor who gets paid in their company stock. Over time, they accumulate so much that it makes up a large percentage of their portfolio.

For others, it is an intentional choice. During the 11-year bull market, many investors piled into tech stocks, given their meteoric rise. Unfortunately, the Nasdaq tech-heavy index has dropped about 30% over the past year, which is devastating for folks without sufficient investments outside this asset class.

Strategy to consider: Utilizing proper diversification, by owning different types of investments in different industries and locations, is just one way to minimize the volatility within your portfolio.

6. Liquidity Risk

This is the risk of not being able to sell your investments at a certain price when you want to. For example, some illiquid investments like private equity, hedge funds, real estate and artwork may take months to sell. An investor with these holdings may find themselves in a challenging situation if they needed immediate cash.

Strategy to consider: Make sure to balance your illiquid investments with liquid ones. While it’s always helpful to have a cash cushion, as mentioned above, in challenging times that may not be enough. Blue-chips stocks and high-quality bonds are wonderful additions to any portfolio and offer a level of liquidity when necessary.

7. Credit Risk

Investments like bonds carry the risk that the issuing government or company will be unable to pay the interest or repay the principal at maturity. While lower-quality bonds have higher potential returns, they also carry a higher probability of default.

Strategy to consider: The ratings of the bonds you own can help you evaluate credit risk. The highest credit rating of AAA represents bonds with the lowest credit risk. Bonds rated below BB+ are considered junk and carry the highest risk of default. Make sure you can afford to lose any money that you invest in junk bonds.

8. Interest Rate Risk

The price of bonds has an inverse correlation to interest rates. As the Fed raises rates, bonds tend to drop in value. We saw that in 2022, with investment-grade bonds dropping double digits due to the aggressive rate hikes.

Since bonds typically represent the “safe” part of an investor’s portfolio, seeing these holdings drop in value can be worrisome.

Strategy to consider: Shorten the duration of your bond holdings. Duration is the weighted average time until the bond’s fixed cash flows are received. It can be used as a measurement of interest rate risk and how much bond prices are likely to change when interest rates move. The shorter the duration of your bonds, the less impactful the change of interest rates will be on your bond holdings.

9. Horizon Risk

An unexpected life event, including job loss, disability, death or a large, unexpected expense, may cause your investment time horizon to change.

Strategy to consider: Proper life, disability, home and umbrella insurance coverage can offer protection for some unexpected events like early death, disability or large expense of fixing damage to your home due to a hurricane. Protecting against the risk of losing your job is a bit trickier. However, a robust cash reserve and the willingness to aggressively cut expenses and modify your lifestyle may alleviate the financial challenges that lie ahead.

10. Longevity Risk

The major concern that many retirees face is outliving their nest egg. No one wants to find themselves in a situation of needing to rely on family, friends or charity.

Strategy to consider: Mitigating longevity risk and ensuring you don’t run out of money requires a multipronged approach. This includes saving into tax-advantaged retirement accounts from every paycheck, delaying Social Security, working longer, considering guaranteed income through an annuity, buying long-term care insurance and evaluating the most cost-effective place to retire. None of these suggestions is easy, and some require planning for years in advance.

However, their combined impact can help you live a dignified retirement without having to worry about spending down your funds.

During challenging markets, various flaws in our financial plan may come to light. Many missteps stem from a failure to assess risk or improperly classifying your own risk appetite.

While these oversights are painful to discover, proactively addressing them can help protect your finances during the next market downturn. More important, it will increase the probability of achieving your financial goals.

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Securities offered through Kestra Investment Services, LLC (Kestra IS), member FINRA/SIPC.  Investment Advisory Services offered through Kestra Advisory Services, LLC (Kestra AS), an affiliate of Kestra IS.  Shenkman Wealth Management is not affiliated with Kestra IS or Kestra AS.  Investor Disclosures: https://www.kestrafinancial.com/disclosures

This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.