BOSTON (MarketWatch)—I don’t know about you, but I’m a little bit
nervous. The Standard & Poor’s 500 is trading close to a four-year
high and the only good reason for that, it would seem, is this: Stocks
like to climb a wall of worry.
My guess, however, is that if you’re like me, you might want to a little
downside protection right about now. After all, it seems more likely
the market will fall rather than rise significantly from current levels.
So what are some good ways to protect your portfolio, and gains if you
have any?
1. “Insure” that portfolio
Well, for some, times like these call for standard off-the-shelf tools
and techniques. They recommend buying ETFs that short the market, or
buying puts, or selling covered calls.
To be fair, however, not all advisers are fond of this approach. “There
are certainly techniques known as ‘portfolio insurance’ that employ the
use of different kinds of options—buying and selling index options can
be used to minimize the downside risk of a diversified portfolio,” said
Dave Yeske, a managing director of Yeske Buie. “But we believe these
techniques are too expensive and don’t add value in the long run.”
According to Yeske, the very use of the term portfolio “insurance” is a
bit of a misnomer. “This is not insurance in the same sense as life
insurance or homeowners insurance,” Yeske said. “These kinds of
insurance protect you from irrevocable loss. A human being who dies
prematurely does not rise from the dead. A house that burns down does
not spontaneously rebuild itself. A portfolio, on the other hand, will
rebuild itself after a cyclical downturn.”
Buying options as “insurance” represents an expense, not an investment,
said Yeske. “Options, after all, are a wasting asset and a zero-sum
game,” Yeske said. “Better to build resilience into your portfolio in
other ways, like allocating an adequate amount to cash and
short-duration, high-quality bonds. Any loss in return potential from
owning cash and bonds will be less than the cost of ‘insurance’ and will
allow you to leave your equities unmolested during a cyclical
downturn.”
Still, there are times when Yeske uses portfolio insurance. “For
example, when a client holds a large, undiversified position in
restricted employer stock, we will use options to protect this client
from the short-term downside risk they face until the restrictions are
lifted and they can liquidate the position in favor of a more
diversified portfolio,” he said.
2. Seek return of capital
Another way to create some downside protection is to seek safe havens.
Rob Schmansky, of Clear Financial Advisors, said U.S. Treasuries, cash,
or income annuities provides short-term downside protection in nominal
terms. “If there’s one place investors run to it’s a guaranteed return
of principal,” Schmansky.
Meanwhile, Stephen Smith, a vice president at Noesis Capital Management,
uses a different approach with his client base, clients who, he says,
“place a premium on capital preservation with the goal of growing their
assets over time within reasonable risk parameters.”
3. Don’t stay fully invested
“We do not have a mandate to always be fully invested,” said Smith, who
manages separate accounts. “There will be periods when it is best not to
be fully invested.”
The key is to manage risk first and foremost, Smith said. He also noted
that one key difference between separate accounts and mutual funds is
this: Many mutual funds must remain fully invested and that’s not the
case for separate accounts.
4. Sell even when you don’t have something to buy
Just because you don’t have something else to buy doesn’t mean you
shouldn’t sell. If the a stock or ETF or mutual fund has hit your price
target, move on. “We will never delay selling a stock that needs to be
sold because we don’t have a suitable replacement at that moment,” said
Smith. “The buy and sell decisions are separate and distinct.”
5. Stop losses
Smith’s firm uses a trailing stop-loss for all positions. “This approach
is both technical and fundamental; not a fixed percentage decline from a
high-water mark,” Smith said. “The key is to not let a small loss
become a large loss if at all possible.”
6. Look at things from all angles
Some investors use a top-down approach, others a bottom-up approach.
Consider instead using both a top-down and bottom-up analysis. “We
strive to stay aware of macro factors, while depending on fundamental
and technical analysis of company and industry dynamics,” Smith said.
“As such, we may have zero exposure to an industry or sector at times.”
One example Smith gave is this: In March 2007, his firm sold all bank
stocks and all but one financial stock. And that was at time when the
financial sector comprised 22% of the S&P 500 weighting. This
remained the case until mid-2009.
7. Use common sense
Smith also said that his firm tries to use common sense when evaluating
new ideas, as well as current holdings. “We do not hold ourselves out as
market timers, as we do not have a timing model that dictates cash
levels or that measures market volatility,” said Smith. “We do employ
quantitative screens to narrow a large universe of stocks down to a
smaller list companies that we then research in greater depth. We try to
be opportunistic in our purchase point, and we trim positions back as
they grow to be relatively large holdings in the portfolios.”
He said one example of this is Apple
AAPL
-1.37%
which his firm trimmed in late March 2012 after a strong rally. “This
element of risk control keeps a position from getting too large and
having an inordinate impact on performance, in the event of a major
correction in the stock,” said Smith.
8. Diversify, diversify, diversify
“We think the best approach to downside protection is simply to maintain
a broad and appropriate degree of diversification; across asset
classes, within asset classes, globally, and across different
currencies,” said Yeske.
Schmansky also said diversification may provide some benefits, but it
isn’t bulletproof. “We saw in the ‘lost decade’ of the stock market that
holding an allocation to bonds, real estate, and a diverse portfolio of
stocks actually provided a nice annual return as compared with the 0%
return of the S&P 500,” he said.
Read Schmansky’s article that showed how diversification across assets
let to a surprising result over the 0% S&P 500 return.
Robert Powell has been a journalist covering
personal finance issues for more than 20 years, writing and editing for
publications such as The Wall Street Journal, the Financial Times, and
Mutual Fund Market News.
