Guarding Your Investment Portfolio Against the Next Downturn
By Ron DeLegge, Editor
May 6, 2009
SAN DIEGO (ETFguide.com) – “What a difference a day made,” is one of the outstanding American songs made popular by the great Dinah Washington. From an investment perspective we might say, “What a difference two months makes!”
If you’ve already forgotten what’s just occurred or perhaps, you’ve been hibernating, let me refresh your memory.
Just two months ago, stocks were in a freefall. As they say in baseball, “They (stocks) couldn’t buy a base hit.” Today, stocks have staged one of the largest rallies in modern history. Since touching March 9th market lows, the total U.S. stock market (NYSEArca: VTI) has rallied by 36%, emerging market stocks (NYSEArca: EEM) are up by a dazzling 50% and international stocks (NYSEArca: VEA) have jumped 40%.
Before suddenly concluding that the worst is behind us, focus on ways to protect your investments. After such a sharp rally, is it time to realize some of the market’s recent gains? What can you do right now to shield yourself from the market’s next downturn?
Let’s analyze some basic investment strategies that can help you to guard your profits.
The Automatic Sale
Many investors have difficulty in pulling the trigger when it comes to selling their investments. And it’s not hard to see the reasons why. After owning a stock, exchange-traded fund, or another type of investment for years, we have the human tendency to become emotionally attached to that investment.
To avoid the internal debate of when to sell your stocks or ETFs, think about using a stop loss strategy. Although it may sound complicated, it’s not. The basic idea is to lock in any gains you may have and to prevent your losses from mounting into the kind from which no recovery can be made. The stop loss sell order triggers an automatic sale of your shares once they hit a pre-determined price. Most brokers will be able to accommodate your stop loss order request. Be sure to ask them.
Hedging Your Investments
Have you ever packed an umbrella for a trip even though it’s not raining outside? What you’re essentially doing is hedging against the possibility of getting drenched on from a rainstorm. The same concept of hedging can also apply to how you manage your investments.
For example, if you happen to own a boatload of Google (NasdaqGS: GOOG) you can hedge that long position with corresponding short technology ETFs like the Direxion Daily Technology Bear 3x Shares (NYSEArca: TYP) or the ProShares UltraShort Technology (NYSEArca: REW). Both TYP and REW are designed to increase in value (with leverage) if technology stocks fall in value. Caveat emptor: Short ETFs are better used as short term hedges or temporary insurance as opposed to long-term protection.
People buy insurance on their homes and cars to protect against the possibility of damage or even worse, catastrophic losses. Presumably, you pay a reasonable premium to the insurance company to protect you. And if your home doesn’t manage to burn down, you don’t complain that you’ve lost your premium. You’re just glad that your home is still standing and that your family is safe. Did you know you can also buy insurance on your investments?
Another strategy to protect your investment portfolio is buying put options, which increase in value when the underlying stock or ETF falls in share price. Any decline in your shares is offset by a corresponding increase in the value of your put options, which you presumably bought as a form of insurance.
Options are sophisticated investment instruments, so if you employ them, get educated or work with a financial advisor that can help you. In the March and April editions of the ETF Profit Strategy Newsletter we thoroughly analyzed and explained various ETF option strategies designed to generate more income, profit in a directionless market and to guard against an uncooperative stock market.
ETFs are versatile investment products that open up the door to investment strategies that were once limited to large financial institutions. The financial flexibility of ETFs is one of the reasons they are gaining in popularity too. Most of the strategies explained above cannot be executed with a portfolio of traditional mutual funds.
As useful as each of these defensive strategies can be in helping you to protect unrealized profits, it’s important to underscore they are not your first line of defense. What is the first line of defense? It’s having a rock solid investment portfolio that matches your financial goals, your level of risk tolerance and your personality. This is where all investors should begin.
Unfortunately, there are a lot of 50, 60 and 70 year old people with the asset allocation of a teenager. What’s wrong with them? Not only do they have the wrong investment mix, but they’re using the wrong investment products! How will they ever achieve financial peace of mind? Grow up and act your age! The correct investment philosophy is one that embraces low tax liabilities and low investment costs. And I’m pleased to report that ETF investing embodies these very principles.