Building a robust investment portfolio: 3 ideas for how to diversify

As inflation decreases and the economy continues to grow, the market is proving more resilient than most forecasters had expected. Yet the picture is complicated. Consumer spending is softening, inflation is still above the Federal Reserve’s 2% target and geopolitical risks are rising.

We expect corporate profit margins to continue to support stock values this year. But diversifying is still a prudent strategy. Now is the time to consider insulating your portfolio against future potential losses, or consider taking short-term tactical positions in specific asset classes as opportunities emerge.

Achieving these goals may be possible with certain financial tools. For example, by using structured products, pre-packaged investment strategies with embedded derivatives, you can improve the diversification of your portfolio, boost your investments’ risk adjusted return potential and create strategies to guard against too steep a future market downturn.

Currently, some structured products are more attractively priced than they have been in years. Why? Because higher-for-longer interest rates have significantly improved the pricing of these products, making them an interesting—and timely—choice for many investors.

To keep your investment goals on track, consider how these financial instruments could help you enhance your portfolio. Here are the strategies worth considering now.

1: Hedge potential losses with buffers

In the current market with high equity valuations and rates, we find structured notes appealing. These are financial products that blend elements of traditional securities, like stocks and fixed income instruments, with derivatives to support specific investment goals. Typically, they can be linked to a variety of underlying assets, including stocks, bonds, commodities or currencies. Some structured notes can be tailored to reduce the impact of a market downturn on your portfolio while still allowing for potential gains.

These strategies can be particularly useful in avoiding common psychological traps identified by behavioral finance, such as hesitating too long to move out of cash after a market dip. However, as they are complex products, structured investments come with risks such as liquidity and counterparty risks, so ensure you fully understand the features – such as liquidity & credit risks—, fees and costs associated, as they may not be suitable for all investors.

To limit potential losses or rebuild an equity holding, investors often turn to structured notes that offer some downside protection against moderate moves in markets with enhanced upside returns to a certain cap, such as buffered return enhanced notes (BRENs). These are issued as debt obligations and are typically linked to the performance of a particular market index, such as the S&P 500, as the underlying asset. Notes with buffers, such as BRENS, can provide a financial—and psychological—safety net by curtailing potential losses through a level of downside portfolio buffers while still offering an opportunity to capture (and enhance) some potential gains. These types of notes are often capped, but there are other types of notes such as “market plus”notes that could offer uncapped returns.  These types of structured notes typically return the investment principal at maturity. However, keep in mind if the issuing counterparty goes under or the underlying falls below a certain level, the BREN may result in a loss of some or all principal.

Despite the credit and market risks structured notes carry, many investors like to use using structured notes to get invested or stay invested – because it provides a level of reassurance. Knowing that the likelihood of losing your entire investment is small , structured notes can help you withstand short-term market fluctuations and remain invested for the long term. These “phase-in” strategies, as they are known, operate on an investor’s behalf to reduce the risk of making an allocation decision at the wrong time.

2: Gain access to diversified income

As strong as the economic recovery has been in recent quarters, there are still plenty of risks: Consumer spending is softening and geopolitical uncertainties loom large. Diversifying your portfolio is essential—and we see different ways, now, to approach earning investment income.

Efficient income generation can be done to complement core bonds. In the event of a specific market scenario, even potential pullbacks, investors can use “cap coupon” notes as sources of diversified portfolio income. Cap coupon notes carry the moniker because they pay a coupon up to a set limit or cap. Depending on the strategy, these notes can also produce positive returns even if the underlying declines, much like long-term bonds.

Cap coupon notes can be advantageous portfolio tools in a stable or “flat” market, allowing investors to earn steady income despite market fluctuations, within a range. As mentioned, some structures may even generate positive returns when the market declines, a payout profile investors often like for uncorrelated returns. As with all structured products, cap coupon notes can lead to potential loss in investments, and come with risks such as interest rate, credit and market risk, so be sure to carefully consider these before incorporating them into your wealth plan.

We also like preferred securities, or “preferreds,” which are not structured products or derivatives, but they are part of the equity capital structure.

At first glance preferreds look like fixed income securities, but they’re actually hybrid securities that have both bond and stock characteristics. They typically offer steady income like bonds, which may help diversify your investments, and they also have the potential for price increases, like stocks.

However, not all preferreds are the same, and they do come with certain risks, including liquidity, counterparty and credit risks. Consider those issued by large financial institutions.

3: Unlock potential opportunities to capture growth

Looking ahead, we expect economic growth to remain strong, even as interest rates remain higher for longer. In this environment, you can use structured notes to complement your core investment strategies, such as an equity allocation. These financial tools allow you to participate in leveraged upside returns of a particular stock or sector based on the strength of your conviction, or position your portfolio to capture future returns without having to deploy more of your capital to buy more stock.

This can potentially enhance your portfolio.

For instance, if you have a specific market view, you can use structured notes to leverage your equity allocation. This is done by customizing your exposure using structured notes such as a return-enhanced note (REN). This type of product aims to capture and amplify positive performance of a selected market sector or asset class, potentially up to a certain cap.

As long as the underlying asset does not close below its initial price at the REN’s maturity, the note will typically pay back the principal amount—plus enhanced upside returns, since RENs include leverage. If the underlying asset closes below the initial price, some RENs offer full or partial principal protection, or some may result in a loss.  The outcome can depend on the specific terms of the REN.

So, for example, if the market is up 10% and the structured note is customized to enhance returns 1.5 times, the position could be up 15%—and possibly outperforming the market—depending on the note’s specific terms.

Right now, with markets making all time highs, it may be daunting to get invested, but structured notes that offer downside protection and compelling upside returns can be an appealing way to get invested and step out of cash.

Conclusion: Preparing for any market eventuality

Stock market volatility is inevitable, but you can prepare for it. For suitable investors, by incorporating structured products and derivatives into your portfolio strategy, you may be able to realize enhanced returns, protect your investments and access diversified sources of income. As geopolitical risks loom large this year, using structured products—particularly structured notes—could help you navigate a fragile world, take advantage of growth opportunities and most importantly, stay invested.

We can help

If you’d like to explore how your J.P. Morgan team can assist you in tailoring strategies and payout profiles to help you meet your wealth goals, please reach out. We have deep knowledge and experience in designing customized strategies for our clients.