We are currently seven years into a 200% stock market recovery that began in 2009 - one of the longest recoveries on record - so it's natural to wonder how much further this bull can run. Additionally, we face unprecedented geopolitical and fiscal risks. In other words, most of us are justifiably concerned, but we don't want to miss out on future potential gains. I personally moved to defend way too early in 2011. That was an expensive move in both absolute and relative terms. I've lost money. Now I can't change my positions because it would likely be selling at the bottom. I'm locked for now, waiting for a correction. Timing is everything.
Fortunately, it's not too late for you. You have alternatives for protecting your investments, and you can decide when you want to start. Here are a dozen choices.
A Dozen Ways to Protect Your Portfolio from Losses
- Become a student of Dr. Downside. Dr. Frank Sortino is the father of Post-Modern Portfolio Theory (NASDAQ:PMPT) that redefines risk as the probability of failing to achieve an objective rather than the volatility measure used in Modern Portfolio Theory (MPT). So called "Absolute Return" strategies are an outgrowth of Dr. Sortino's work. Dr. Sortino has written two books on managing downside risk.
- Buy insurance. Buy puts or other derivatives. The challenge is to buy before the correction, because the cost of insurance increases with risk, as it should.
- Time the markets. Timing is very challenging, but a few providers have successful track records. Can they do it again? Most do not get it right twice in a row, namely getting out before the correction and then back in when the recovery starts. Look for the best crystal balls.
- Exploit a theme. Being on the right side of a theme, like rising interest rates or high inflation, protects against associated losses, and profits from its realization.
- Diversify. Most of the time asset class prices do not move in tandem, although this tends to be less true in big market declines.
- Manage tail risk. By monitoring estimates of current semi-variance, asset allocations can be adjusted to maintain an acceptable level of loss exposure, plus derivatives can be employed as needed.
- Buy "guaranteed" return products. "Cash and calls" are the mathematical equivalent of "stocks and puts." This is the basis for "structured products" that guarantee against loss by buying zero coupon bonds that mature with a face value of the amount invested, with the balance invested in stock market calls. Structured products work best in high interest-rate environments because zero coupon bonds cost less.
- Place stop-loss orders. You can set floors on the losses of your security positions.
- Common sense. We all "see" things that have to change, someday. For example, we all know interest rates are being manipulated to artificially low levels. Someday that manipulation will have to end. It's common sense to protect against the consequences of rising interest rates.
- Buy volatility. Fear creates high volatility estimates, like the VIX index. It also generates panic selling. Buying indexes like the VIX can offset the losses of panic selling.
- Buy low volatility funds. The seminal research of Dr. Robert Haugen has gone mainstream in recent years, prompted by both fear and greed. Dr. Haugen discovered a "free lunch" in low volatility stocks. They produce higher returns for their risks than theory predicts. High-dividend funds are a variant on this play.
- Buy hedge funds that actually hedge. Hedge funds have the freedom and flexibility to use all of the techniques mentioned in the preceding, and more. But be careful. Some hedge funds are very risky, especially those employing high leverage.
Each of these protections comes with a cost, a cost that is usually wasted if markets continue to go up. Such is the nature of insurance. We hope the premium is wasted.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.