With the recent pull-back across equity markets and scare-tactic headlines warning investors of a dismal economic outlook ahead, investors might be persuaded to run for the hills. But before you cash out and start storing cash under the mattress, consider other ways you might be able to protect yourself in highly volatile or down markets.
Of course, any portfolio protection strategy begins with a long-term investment horizon and a disciplined plan. Short-term, emotional decision-making is the enemy of successful investing. Instead, begin by focusing on diversification and arming one’s portfolio with investments that tend to “zig” when others “zag.” For example, one may diversify a traditional 60-40% stock to bond-like mix by adding international stocks and bonds, emerging markets, treasury inflation-protected securities, commodities and real estate.
In addition to these more common asset classes, there are other ways to attempt to reduce downside risk and volatility while still seeking to deliver a desired rate of return. Fixed income exposure, the greater use of trading strategies, equity-indexed products (like annuities), structured notes and inverse products may provide additional downside protection benefits that many investors desire.[gallery]
Be prepared, however, because while many of these products deliver on diversification, they are not without risk and major drawbacks. Some of the potential short-comings of these strategies include:
- Cost - many of these products are layered with fees;
- “Black boxes” - minimal transparency into the actual operations of the strategy;
- Illiquidity - resulting from extended lock-up periods;
- Counterparty risk – default risk associated with the institutions involved;
- Greatly reduced upside return potential;
- Inconsistency of the product behaving as advertised; and
- Implementation challenges – some have requirements limiting client participation while others have significant operational hurdles.
Other strategies, such as an “option overlay” strategy, may have fewer disadvantages and more potential to protect against the downside. At its core, this approach uses puts, calls and other options techniques to create a floor beneath which the portfolio’s value cannot fall. These option techniques are often associated with protective measures applied to individual stocks, and may be especially beneficial when one is faced with high exposure to a company while retaining a very low cost basis.
The take-away is that long-term investing and diversification among low-correlated asset classes should remain the foundation of your portfolio protection investment strategy. And, while the economic news may not be as dire as the recent headlines make it appear, it also may be worth investigating alternative investments to seek to reduce the volatility of your portfolio – just remember that, as with any new product or asset, make sure you proceed with caution and due diligence before you invest.
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