By Jack Hough

The S&P 500 index of U.S. stocks is down more than 10% from its Feb. 19 peak. Is that just a wobble, or a warning? We'll let you in on a secret: No one knows for sure.

That's the marvelous, monstrous trade-off of investing in stocks. Few things increase wealth over time for ordinary savers like shared ownership of businesses. The U.S. market has returned 9.7% annualized since 1900, thrashing bonds at 4.6%, Treasury bills at 3.4%, and inflation at 2.9%, according to UBS. But history shows that stock market drawdowns of 20%, or even more than 50%, can strike without warning. And it can take just a few years to bounce back, or more than a decade.

While we're spilling secrets: We can't even say for certain what's driving stocks down now. You might have heard that President Donald Trump's quick draw on tariffs with key trading partners has got investors second-guessing the assumption that he will proceed cautiously on matters that might upset the stock market. Maybe. But meanwhile, Japan raised interest rates in January, matching the highest level since 2008, souring big traders on one of their favorite sources of cheap borrowing for buying U.S. tech shares. Or maybe it's just that the U.S. market looks pricey, at 20.5 times this year's projected earnings.

Deutsche Bank argues in a recent note that conditions resemble the early stage of the dot-com stock bust in 2000. Tech stocks are tumbling, while defensive sectors are climbing. Back then, the S&P 500 finished the year down just 10%. Then bearishness broadened, and the next two years brought drops of 13% and 23%.

Yikes. But there have been many crash warnings over the past decade, and one actual crash, when the Covid-19 pandemic emptied theme parks, office buildings, and restaurants seemingly overnight. The S&P 500 has nonetheless returned 215% over that stretch.

So don't dump stocks wholesale, but if you're nervous, consider ways to hedge the risk of a crash. There are lots of lousy ways to do that, and a few good ones. Here are a handful, running roughly from worst to best.

Inverse Exchange-Traded Funds

Don't even think about it. These are for traders, not long-term investors. You might have heard "compounding" called the most powerful force in the universe; these ETFs can put it to work against you. They use derivative securities to bet against the stock market for a day at a time. One result of that is they can't accurately offset market moves for longer periods. Another is that fees are typically high. And some pile on leverage. Direxion Daily S&P 500 Bear 3x Shares charges 1.02% a year. It's up 21% this year. Over the past decade, it's down 99% -- the fund uses periodic reverse splits to keep the share price from falling to pennies.

Options

You can buy put contracts to bet against a stock or index. That's relatively risky, but your downside is limited to the cost of the puts, which can fall quickly in value or expire worthless. You can also write covered call contracts, whereby you sell to someone bullish a bet that a stock will go up. That's less risky because you pocket cash up front, but if stocks rise, you can miss out on the upside. And some investors do both simultaneously -- they sell calls and use the cash to fund the purchase of puts.

One problem is that while traditional stock market investors who suffer selloffs can simply wait to eventually be proven right about their optimism, options have time value that is constantly eroding, so users must be right quickly. In 2022, when the S&P 500 lost 19.4%, the index zigzagged lower throughout the year, rather than collapsing suddenly. An investor who used a typical options hedging strategy lost about as much as the market, says Amy Wu Silverman, head of derivatives strategy at RBC Capital Markets.

Raising Cash

It depends how much we're talking about, and for how long. Since it's impossible to know when the stock market will fall, only that stocks tend to go up more they go down, you'll likely get the timing wrong. Then stubbornness will kick in, and you'll decide that you're not wrong, just early. By the time you get to despair, and capitulation, history suggests that you'll be buying back in at a much higher price. Or you might luck out and time the whole thing beautifully. Best to lean on luck for your March Madness brackets, however, not your long-term savings. But keep enough cash to meet emergency needs.

'Safe' Stocks

Maybe. The challenge is telling which ones are safe. One of the bedrock principles of modern investing is that risk is related to returns. But at the individual stock level, no one has come up with a way to satisfactorily measure risk. Sure, you can pull up a stock quote online that lists a purported risk measure called beta, usually based on a price regression that shows how volatile a stock has been relative to the S&P over the past five years or so. But what you'd really like to know is how volatile it will be in the future, and neither quote pages nor soothsayers can tell you that.

Careful about reputational defensives, too. Packaged-food makers and electric utilities have run up in recent weeks while the market has stumbled. But Big Food has struggled with slipping revenue, and it's unclear whether the health preferences of young consumers, or the obesity meds of older ones, are playing a role, or if it's just inflation and stretched household budgets. Utilities are thriving amid demand for data-center watts. But the Utility Select Sector SPDR ETF, which tracks a basket of them, is up 21% over the past year, versus 8% for the S&P 500, not counting dividends. At 18 times earnings, is it still defensively priced?

Better to just look for reasonably priced, well-run companies with manageable debt and reliable and rising cash flows, wherever that's playing defense or offense.

Equal Weight S&P 500

We get it. By not weighting companies by market value, you get less of the stuff that has run up greatly in price, and more of the stuff that hasn't. Invesco S&P 500 Equal Weight ETF reported a 14% weighting in information technology at the end of last year, versus 32% for SPDR S&P 500 ETF Trust. That has served the equal-weight one well of late.

It's just that it's a bit weird and arbitrary. Isn't tech more important than that? Why, again, should we put so much more than the market in utilities and less in communications, just because there are many small power companies and few large phone companies? Why put 6% in real estate investment trusts when they're only 2% of the market -- and even though the other 98% of companies own real estate, too? Better to just buy what you're indirectly targeting, which is value. Speaking of which...

Value Stocks

They're supposed to do better than growth stocks over time. They have, over the longest periods. Since 1926, a dollar invested in value stocks has turned into $131,534, versus $11,744 for growth stocks. That's based on the ratio of price to book value, using data compiled by Kenneth French at Dartmouth, and reported by UBS. Recent decades disagree, however. The S&P 500 Growth index has shot ahead of S&P 500 Value since the early 1990s -- otherwise known as forever to a 50-year-old saver who graduated from college then.

We aren't sure where that leaves us. But if you're eyeing adding a sliver of an equal-weight fund for its value tilt, consider a more direct approach, like the Invesco FTSE RAFI US 1000 ETF. It weights companies by book value, cash flow, sales, and dividends and has done a smidgen better than equal-weight, both this year and over the past decade.

Overseas Stocks

Yes, please. If you're a U.S. investor, you've heard for much of the past half-century that diversifying overseas can reduce portfolio risk, and if you've followed that advice, the results have been disappointing -- both the returns and the volatility. But Europe and Japan look cheap, and both markets are perking up lately. So far this year, the iShares MSCI Japan ETF has made 4%, and iShares Core MSCI Europe, 13%, versus a 5% decline for SPDR S&P 500. We hesitate to call this the beginning of a long-awaited rebound for both, but maybe. Japan is 6% of the world market, and Europe, around twice that, if you're wondering how much to allocate.

China is running up even faster this year. It's an important market, but a state-controlled one, with dubious ownership rights for outside investors. Long-term returns have been poor, and that's only going back to the 1990s -- not the expropriation of private property following the 1949 communist revolution. But mainland China is 3% of the world market, if you're interested, and iShares MSCI China offers access. Or just buy Vanguard Total World Stock ETF, if you can live with only a 65% U.S. weighting.

Bonds

Now we're talking. Long-term returns, as we mentioned in the beginning, are ho-hum, but they have beaten inflation -- except for some decadeslong stretches when they didn't. But the real appeal is that correlations with stocks are usually low, which is just the thing for likely cushioning during, but not immunity from, stock crashes. Plus, the way stocks have run up over the past decade, your bond allocation might need topping up.

For passive exposure, there's Schwab U.S. Aggregate Bond ETF, which costs next to nothing and yields 4.4%, with an average duration of just under six years. If you prefer to dial in your mix, Schwab fixed-income strategist Collin Martin likes high-rated corporate bonds yielding 4.5% to 5.5%, and Treasury Inflation-Protected Securities, or TIPS, some of which yield 2% before inflation adjustments, near the high end of their 20-year range.

Write to Jack Hough at jack.hough@barrons.com

This content was created by Barron's, which is operated by Dow Jones & Co. Barron's is published independently from Dow Jones Newswires and The Wall Street Journal.

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March 14, 2025 01:00 ET (05:00 GMT)

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