By Robert Powell, MarketWatch
Last Update: 12:01 AM ET Aug 22, 2012
BOSTON (MarketWatch)I dont know about you, but Im a little bit nervous. The Standard & Poors 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 youre 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 optionsbuying 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 dont 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 theres one place investors run to its 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. Dont 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 thats not the case for separate accounts.
4. Sell even when you dont have something to buy
Just because you dont have something else to buy doesnt mean you shouldnt 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 dont have a suitable replacement at that moment, said Smith. The buy and sell decisions are separate and distinct.
5. Stop losses
Smiths 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 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 isnt 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 Schmanskys article that showed how diversification across assets let to a surprising result over the 0% S
Robert Powell is editor of Retirement Weekly, published by MarketWatch. . Follow his tweets here.
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