Tutorial: Downside Protection

May 28, 2024

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This guide will help you understand and try to improve your Downside Protection Score in PortfolioPilot. Found on the Analysis page, as part of your overall Portfolio Score, the score assesses how well your portfolio can withstand financial shocks and stresses, with the goal of helping you avoid significant losses during tough economic times. It is not independent from risk-adjusted returns, and part of our goal with an integrated Portfolio Score is to help you see your portfolio as one set of interconnected assets, rather than a set of disconnected pieces

What is Downside Protection?

The Downside Protection Score evaluates your portfolio's resilience against extreme market events. A higher score means your investments may be better shielded against potential risks.

Key Factors of Downside Protection

Let's break down what influences your score and how you can improve it:

1. Holdings Diversification

What it means: Spreading your investments across many different assets to reduce the risk tied to any single one.

Example: Instead of investing 80% of your net worth in just three tech companies, diversify by including stocks from different industries such as healthcare, utilities, and consumer goods.

2. Commodity Driver Risk

What it means: Exposure to risk associated with unexpected fluctuations in commodity prices.

Example: If your portfolio has a heavy allocation in mining stocks, an unexpected fall in metal prices could negatively impact your investments.

3. Sector Diversification

What it means: Investing across various sectors to mitigate losses if one sector underperforms.

Example: Balance your investments between sectors like technology, finance, healthcare, and consumer services rather than focusing only on one.

4. Growth Driver Risk

What it means: Sensitivity of your portfolio to changes in economic growth forecasts.

Example: High reliance on stocks that benefit from economic expansion (like real estate and consumer discretionary stocks) may risk declines if GDP growth slows.

5. Country Diversification

What it means: Spreading investments across multiple countries to avoid risks associated with any single country.

Example: Along with U.S. stocks, investing in European, Asian, and emerging market stocks to protect against region-specific economic issues.

6. Inflation Driver Risk

What it means: How your portfolio might be affected by unexpected rising or falling inflation rates.

Example: Holding inflation-sensitive assets like Treasury Inflation-Protected Securities (TIPS) or commodities can hedge against inflation risk.

7. Interest Rate Risk

What it means: The impact of surprising interest rate changes on your investments, especially bonds.

Example: If interest rates rise unexpectedly, bond prices typically fall. Diversifying into stocks or real estate can mitigate this risk.

8. Credit Risk

What it means: Sensitivity of your portfolio to changes in the credit conditions of the market, which can affect the value of your investments.

Example: During a credit crunch, where borrowing becomes more difficult and expensive, high-yield bonds might lose value. To mitigate this, diversify your holdings to include stable, investment-grade bonds that are less affected by tightening credit conditions.

9. Liquidity Risk

What it means: Exposure to fluctuations in market liquidity, affecting how easily investments can be bought or sold without impacting their price.

Example: During market turmoil, liquidity can dry up, making it difficult to sell assets at desired prices. Holding a mix of highly liquid assets like major index stocks or government bonds along with less liquid assets like niche market stocks or real estate can balance this risk.

10. Asset Class Diversification

What it means: Investing in different types of assets (stocks, bonds, real estate, commodities) to spread risk.

Example: Including a mix of equities, fixed income, real estate investments, and commodities in your portfolio to buffer against market volatility.

How to Improve Your Score

To boost your Downside Protection Score, diversify your investments across different assets, sectors, and regions. Regularly review your portfolio to ensure it aligns with these principles, adapting as economic conditions change.

Remember, a well-diversified portfolio is a great defense against unexpected market shifts. Use these insights to make smarter investment choices and protect your financial future.

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