With the market at all time highs, many investors are wondering when the rug will get pulled out and this market comes crashing down.
My belief and research shows that the risk/reward ratio right now favors being conservative. Are we willing to lose 30-40% of portfolio value in an attempt to get 3-4% in market gains? I say lose 30-40% because certain conditions that we are in right now were in place before we had market corrections/crashes and that magnitude loss is not out of the ordinary.
So, how can an investor stay invested but protect their portfolio?
First, if you are working with someone that is managing your money, please find out what measures they have in place to protect against a major downturn. If they don't have a good one, it might be time to find someone else. Hold on and hope is not a strategy.
- Asset Allocation: This is a common way to try and reduce the volatility of a portfolio. Volatility is used as a measurement of risk, but I would define risk as how likely and how severe an event can be. Asset allocation works best with non-correlated asset classes, i.e. bonds to stocks.
- The problem now is, the bond market is also at an all time high and bonds have their own risks, so they may not give adequate protection.
- Trailing Stop/Stop Loss Orders: These are orders you can place on existing positions that tell the brokerage firm to sell if it hits a certain price. For example, you purchase AAPL at $100, but want to limit your loss to 5%. You can place a stop loss order to hold onto it as long as it trades above $95, but once it gets there, it will sell as either a market order or limit order. This is a good tool to take the emotion out of a trade if it goes against you. A Trailing Stop is actually a moving target that will adjust the sell price upwards as long as the price is moving up.
- Using the same example, if you set a 5% trailing stop on AAPL, and AAPL keeps moving up, the 5% limit order will keep adjusting up with it. One caveat, the more volatile a stock, the more careful you should be setting your sell price, as you don't want it to sell based on normal market action if that isn't your intent.
- Options: If you trade options, a protective put can be purchased to protect against losses. This is more like buying an insurance policy. It costs you money, and hopefully it isn't needed, but if something really bad happens to the market, the insurance would kick in. Today, you can buy the SPY for around $200, and buy a December 2014 protective put for about $1.53 per 100 shares. This works out to: $200*100 shares = $20,000 purchase. Buy 1 December 2014 put at $1.53*100 = $153.
- What you are doing here is saying, I want to own the stock market, so I invest $20k. I have limited my loss to 10% because if it gets below $180*100=$18,000, I will sell my shares to the person I bought the put from for $180/share. Now, the problem with options is, the time component. If in December, SPY is above $181, the option expires and you no longer have the insurance, and would have to repeat this process or risk being unprotected. Additionally, if the stock price drops rapidly, the price of the put you purchased will increase, and you can then sell the put for a gain, offsetting the loss you experienced. (This is oversimplification, but in general this is how it works.)
- With volatility so low right now, purchasing insurance for the portfolio is very inexpensive. If volatility spikes as measured by the VIX, selling calls against your position is another way to give you some downside protection, where you become the insurer. There are pros/cons to each of these, so please work with someone or do research before implementing these ideas.
- Market Timing: This one I hesitate to write about as it has been proven over and over that individual investors and most pros have a very difficult time with this one. When you are looking at a chart of a stock or the market, it is extremely difficult to predict with any accuracy where that stock or market will be in 2, 3, 6 months or beyond. The market is a dynamic place and the information inputs almost impossible to predict. On top of that, you have to be able to interpret how investor behavior will react to those events!
- If you bought XOM at $80 and it's now at $98, you are probably pretty happy. If you bought XOM at $105 and its now at $98, you are probably not happy. The company is the same, but two completely different investor experiences and possibly two different courses of action taken by those investors because of how they FEEL about their position. Investor behavior is a powerful thing.
Below is a chart of the SP 500 with recessions shaded in gray. A couple of notes: the market starts selling off before the recession becomes apparent. Also, it has been a long time without a meaningful correction. The market bottomed in February/March 2009, and there hasn't been a 20% correction since, although 2011 was close.
The market may continue moving higher, but it's time to start exploring ways to protect the portfolio and position yourself for better entry points once it happens.
Disclosure: The author is long AAPL, IVV.
Additional disclosure: Disclosure: Kerry Prazak, CFP® is the owner and portfolio manager of East Lake Financial, LLC, a Registered Investment Adviser. Kerry Prazak, East Lake Financial, and/or its clients may hold positions in any ETFs, mutual funds, and/or any investment asset mentioned above. The comments above do not constitute individualized investment advice. The opinions offered here are not personalized recommendations to buy, sell or hold securities. Please do your own research. Thank you!