How to Protect Your Portfolio from Stock Market Earthquakes?

Engineering and construction safety experts always focus on a building's ability to withstand shocks and earthquakes and remain unaffected for long periods, testing soil, building materials and other important elements to ensure the safety of the planned building.

Similarly, an investor must evaluate his portfolio after risk assessment; if the building is threatened by earthquakes, the portfolio is threatened by market shocks and fluctuations, and if the engineer's means to avoid the destructive impact of earthquakes is to choose building materials and its location, the investor's means is to distribute risks in the portfolio and choose stocks.

Value at Risk

The "Value at Risk" tool is one of the most important metrics used by financial institutions to determine the worst-case scenario for expected loss in a stock portfolio over a specific time period.

The basic idea behind this model is to formulate a "single financial number" that summarizes the total threats facing capital, instead of relying on emotional expectations or momentary guesses that dominate the decisions of small traders during sharp downturns.

To translate this mathematical concept into practical numbers, investment funds use the "historical simulation method," which specifically relies on monitoring actual daily returns of assets over 250 trading days (the period representing a full year of actual work in financial markets).

The results are then arranged in ascending order from the largest recorded daily loss to the largest daily profit, in order to isolate the "noise" resulting from daily trading and obtain a real measure of the stock's volatility over a year, giving a solid and clear picture of its stability.

Once these returns are arranged, a point is determined that separates the worst 5% of days from the rest of the sample when targeting a 95% confidence level, helping the portfolio manager set prior scenarios and specific points for intervention by selling or buying to protect liquidity, instead of leaving the investment portfolio vulnerable to random market fluctuations or making decisions based on momentary panic.

For example, if an investor owns stocks worth 500,000 riyals, and the statistical data arranged in ascending order for the past year shows that the percentage for the worst historical scenarios (the cut-off point at the worst 5% of days) was -1.8%, then the Value at Risk calculation is done through the following arithmetic equation:

500,000 × 0.018 = 9,000

This result means there is 95% confidence that the daily loss of the portfolio will not exceed 9,000 riyals, while there is only a 5% probability that the immediate loss will exceed this barrier due to sharp and unexpected random shocks in overall market liquidity.

It can be said that there are three types of portfolios according to Value at Risk:

Types of Portfolios According to Value at Risk

Daily Value at Risk Ratio (at 95% confidence level

Portfolio Type

Value at Risk for a portfolio worth one million riyals

0.5% to 1.0%

Suitable for older investors or those primarily seeking capital protection, relying on stable blue-chip stocks with periodic dividends and low volatility.

The acceptable daily threat ceiling ranges between 5,000 to 10,000 riyals as the maximum loss under normal conditions.

1.0% to 2.0%

The most common distribution pattern; relies on balancing defensive stocks and growth stocks across multiple sectors to achieve balanced growth.

The statistically acceptable daily threat ceiling ranges between 10,000 to 20,000 riyals, a range that balances natural fluctuations and profit opportunities.

2.0% to 4.0% (or higher)

Suitable for younger investors or funds pursuing high-growth stocks (such as technology sectors and start-ups) with high volatility and high standard deviation.

The acceptable daily threat ceiling jumps to 20,000 to 40,000 riyals, representing an aggressive risk that requires high psychological and financial resilience, considering the possibility of losing a large part of capital in just a few trading sessions.

Stock Price Dispersion

The assessment of portfolio strength does not stop there, but extends to measuring threats associated with each company individually through the "standard deviation" indicator, which is the main statistical measure that determines the dispersion of daily stock prices from their historical average over a specific time period.

The widening of this dispersion reflects increasing volatility and difficulty in predicting the daily cash flow path of the asset and its potential to swing quickly in either direction, up or down.

The difference is evident when monitoring high-volatility stocks such as technology and medical companies, including the biotechnology company "Moderna," whose annual standard deviation records high levels exceeding 45%, due to its valuation depending on sudden variables such as clinical trial results or unexpected government decisions, raising uncertainty levels around the price.

In contrast, a stable defensive company in the food sector such as "McDonald's" records a low standard deviation historically around only 15%.

This stability is due to the company's operational nature; demand for its products remains largely stable and steady even during economic recessions, giving its cash flows natural protection against sharp shocks.

This contrast confirms that stocks with violent dispersion cannot be treated with the same relative weights as stable assets; a stock with high deviation requires detailed study and reducing its share within the portfolio to avoid sudden price fluctuations.

Holding highly volatile assets with large relative weights makes risk management complex and often ends in facing forced position liquidation shocks.

This analysis aligns with "risk assessment" mechanisms where company fundamentals are compared to sector averages; for example, applying to a company like "Caterpillar," we find its debt ratio of 1.25 compared to the sector average of 1.10 places it in the medium risk range.

But the strength of the company's free cash flows, which exceed $10.5 billion annually, and its interest coverage ratio of 16.4 times, completely offset this risk; therefore, the company holds a place with some funds that favor conservative portfolios, despite its relatively high debt.

Sensitivity to Fluctuations

Among the most important comprehensive risk assessment tools is the calculation of the "beta" coefficient, which measures the sensitivity of an individual stock's response to the movement of the general market index, and represents the dividing line between defensive investment and high-risk offensive investment, based on the degree of the asset's interaction with the general economic cycle up and down.

For example, we find that a company like "AMD," which produces electronic chips in the technology sector, moves with a high beta coefficient of 1.68, meaning, mathematically, that if the S&P 500 index declines by 10% due to interest rate or inflation pressures, the company's stock is theoretically expected to fall by approximately 16.8% due to its high sensitivity to overall liquidity fluctuations.