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As we mentioned in a post last month, in The Little Book That Beats The Market, Joel Greenblatt described his "Magic Formula" -- a strategy that returned an incredible 30.8% per annum in backtests over a 17-year period (from 1988 to 2004). Even more incredible was that the strategy had only one down year during those 17 years (2002), and in that down year, it was only down 4%.

Reflecting on real world declines 10 times as large

Last year, Greenblatt reflected on the crash of 2008, which didn't leave Magic Formula investors unscathed:

To keep the lesson short, here's what I think you should take away from the experience. An investment strategy where 100% of your assets are invested in the stock market (even with no leverage/margin account, etc.) can result in a drop of 40% or more in your net worth in any particular year (duh, you're probably thinking). But that's so important to know (and plan for!). If you can't live with a drop of that size, you can't put all your money in the market.

A simple way to reduce stock market risk

Greenblatt was describing one simple way of reducing your risk associated with investing in the stock market: Reduce how much of your money you invest in stocks. He did note later in that essay, though, that he thinks most investors should keep a significant percentage of their investing money in stocks.

Another way to reduce risk

For investors who take Greenblatt's advice, and decide to invest a significant percentage of their assets in stocks, another way to potentially reduce risk is to hedge. Recall from our previous article ("Hedging Market Risk by Buying Puts on ETFs That Track Indexes") the distinction between idiosyncratic, or stock-specific risk, and market risk:

Diversifying among a basket of different stocks reduces idiosyncratic (or, stock-specific) risk, but not market risk. An example of idiosyncratic risk would be if news broke that the CFO of a company you owned stock in had been cooking the books. In that case, you’d obviously be better off if you’d had your money diversified among five or ten different stocks instead of having all of your money in that one, shady stock. When the market tanks though, nearly all stocks get hammered. That’s market risk.

Diversifying against idiosyncratic risk

If you follow the Magic Formula and invest in a basket of 20-30 stocks per year, that diversification can ameliorate idiosyncratic risk. Similarly, by making a point of selecting Magic Formula stocks from among different industries, you may be able to ameliorate industry risk.

Hedging with optimal puts

Optimal puts are the ones that will give you the level of protection you want at the lowest possible cost. With Portfolio Armor (available in Seeking Alpha's Investor Tools store, and as an Apple iOS app) you just enter the symbol of the stock or ETF you’re looking to hedge, the number of shares you own, and the maximum decline you’re willing to accept (your threshold), and then the app uses an algorithm developed by a finance Ph.D candidate to sort through and analyze all of the available puts for your position, scanning for the optimal ones.

Decline Thresholds

You can enter any percentage you like for a threshold when using Portfolio Armor (the higher the percentage though, the greater the chance you will find optimal puts for your position). The idea for a 20% threshold comes, as I've mentioned before, from a comment fund manager John Hussman made in a market commentary in October 2008:

An intolerable loss, in my view, is one that requires a heroic recovery simply to break even … a short-term loss of 20%, particularly after the market has become severely depressed, should not be at all intolerable to long-term investors because such losses are generally reversed in the first few months of an advance (or even a powerful bear market rally).

Essentially, 20% is a large enough threshold that it reduces the cost of hedging but not so large that it precludes a recovery.

Hedging costs of Magic Formula stocks

The table below shows the costs, as of Friday's close, of hedging 30 Magic Formula stocks with market caps of $2 billion and above against greater-than-20% declines over the next several months, using optimal puts. For comparison purposes, I've also included the costs of hedging the SPDR S&P 500 ETF (SPY) against the same decline.

How costs are calculated

To be conservative, Portfolio Armor calculated the costs below based on the ask prices of the optimal put options. In practice, though, an investor may be able to buy some of these put options for less (i.e., at a price between the bid and the ask).

Symbol

Name

Cost of Protection (as % of Position value)

(NASDAQ:ADI)

Analog Devices, Inc.

3.07%**

(NASDAQ:APOL)

Apollo Group, Inc.

6.14%***

(AMAT) Applied Materials, Inc. 4.38%***
(NYSE:HRB)

H&R Block Inc.

10.55%***

(NASDAQ:CA) CA, Inc.

4.42%***

(NASDAQ:CEPH) Cephalon, Inc. 0.82%***

(NASDAQ:CSCO)

Cisco Systems

3.94%***

(NASDAQ:DELL)

Dell, Inc.

5.83%***

(FRX) Forest Labs, Inc. 2.44%***

(NYSE:GME)

GameStop, Inc.

6.77%***

(GD) General Dynamics Corp. 3.40%***
(GILD) Gilead Sciences, Inc. 3.23%***
(NYSE:HPQ) Hewlett Packard Co. 2.85%***

(NYSE:ESI)

ITT Educational Services, Inc.

10.85%***

(NASDAQ:INTC)

Intel Corp.

3.99%***

(NASDAQ:KLAC)

KLA-Tencor Corporation

5.14%**

(NYSE:LPS)

Lender Processing Services, Inc.

12.5%**

(LMT) Lockheed Martin Corp. 2.03%**

(NYSE:LO)

Lorillard, Inc.

6.22%**

(NASDAQ:MRVL)

Marvell Technology Group, Ltd.

5.41%**

(MHP)

McGraw-Hill Companies Inc.

3.16%***

(MRX) Medicis Pharmaceutical Corp. 5.66%***

(NASDAQ:MSFT)

Microsoft

2.64%***

(NYSE:NOC)

Northrop Grunman Corporation

2.36%***

(NYSE:OSK)

Oshkosh

7.17%***

(NYSE:RTN)

Raytheon Company

3.36%***

(NASDAQ:SNDK)

SanDisk Corporation

7.90%***

(NYSE:TER)

Teradyne, Inc.

10.72%***

(NASDAQ:VECO)

Veeco Instruments, Inc.

12.35%***

(SPY) SPDR S&P 500 1.51%**

*Based on optimal puts expiring in November, 2011

**Based on optimal puts expiring in December, 2011

***Based on optimal puts expiring in January, 2012

Hedging against market risk

As the table above shows, the costs of hedging some of these Magic Formula stocks can be quite expensive, even when using the optimal puts. If you are concerned about market risk, and content to let diversification ameliorate your idiosyncratic risk, you may want to consider hedging against market risk instead.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.