If you are like me, when you fly a commercial airline, you take a moment to locate your nearest exit—in case of emergency, you might need to evacuate the aircraft. That does not mean you impulsively jump out immediately, however; you just want an exit strategy.
Similarly, with the S&P 500, Dow Jones industrial average and NASDAQ all trading close to all-time highs, I am a bit cautious. This might be a good time to identify the downside protection for your portfolio. Downside strategies can help investors protect against significant losses.
The first tool many investors use to reduce risk is diversification among asset classes with low correlation. However, simply diversifying equity with fixed income, for example, does not do enough to limit risk. A traditional portfolio of 60 percent equity, 40 percent fixed income derives more than 85 percent of portfolio risk from the equity component— so, true portfolio risk is highly concentrated and highly correlated. For example, the last two peak-to-trough market drawdowns of 20 percent or more for a 60/40 portfolio were -32.54 percent from October 2007 to February 2009 and -22.82 percent from August 2000 to September 2002.
Substantial tumbles are more common than many investors realize. The S&P 500 Index has experienced 18 drawdowns of 20 percent or more since 1950, averaging one about every 3-1/2 years. We have not had this type of drawdown in 7.4 years.
In my experience, it is better to start implementing protection strategies during favorable market conditions, such as today.
What are some ways to protect your portfolio from a large drawdown? Here are a few off-the-shelf ideas. All have benefits and drawbacks, and none is perfect by itself:
■ Insure your portfolio. Look at buying exchange-traded funds that short the market, or buy put options or sell covered calls. These might cushion the downside, although they also might limit the upside should markets continue to rise.
■ Stop losses. The idea is to not let a small loss become a large loss if at all possible. You can use “trailing stop” orders based on a set percentage or fixed amount. The drawback here is that you might see your position bounce higher after the sell order is executed.
■ Price target. It is OK to sell even if you do not have something else to buy. If your holdings hit a price target, you should not delay selling. Buy and sell decisions are separate actions.
■ Technical triggers. Consider simple tried-and-true technical-analysis triggers such as moving averages. If your holding goes below a predetermined moving average, sell it with no questions asked. If you really like the holding, buy it back once it moves back above a preset moving average. The downside here is you can get whipsawed and lose out on potential gains in a choppy market.
Should you need to evacuate the aircraft, floor-level lighting will guide you toward the exit, because the lighting was installed before the emergency. Now is the time to exercise similar caution to prepare for an investing emergency.•
Ken Skarbeck, whose every-other-week column normally appears here, has the week off. Coan is managing partner at Ploutos Communication LLC, a financial education and portfolio strategy company. He can be reached at (317) 537-7801 or email@example.com.