In the world of finance, some would argue that keeping money is as difficult, if not more so, than making it in the first place. The stock market has been trending higher for years now, likely making many investors millionaires in the process. The problem now, however, is that many of those newly-minted millionaires may not know when to get out of the market that built their fortune and could risk losing all or a large portion of the gains made in recent years.
Unbeknownst to many market participants, there are ways to reduce market risk following a large move higher like the one that has been seen in the last decade. These methods, while imperfect, may prevent a serious market decline from doing significant damage to a portfolio while some still allow for further upside if the market does continue to rise. The method chosen by investors to protect their portfolios may depend on several factors including overall risk tolerance, investment choices, time frame and more.
Portfolio Diversification and Balancing
One of the simplest, yet most effective ways to hedge portfolio risk is to avoid putting all of your eggs in one basket. Portfolio diversification is one of the keys to long-term success and may not only smooth volatility but may even allow for possibly higher net returns over the long haul. Investors who only invest in U.S. stocks, for example, could be hit hard by a major U.S. recession. Investors who have stocks in other nations may not only avoid getting hit as hard, but may also participate in any upside seen in markets outside of the states.
Portfolio rebalancing is also a key component of proper portfolio diversification. A portfolio that has most of its assets in stocks, for example, may need to add more bond exposure as the investor ages. A young investor holding a lot of bonds with little stocks, on the other hand, may need to rebalance and add more equity exposure to increase long-term return potential. Whatever the case may be, it is very important to examine your portfolio on a regular basis to determine if any adjustments are necessary at that time based on market behavior. Performed regularly, these adjustments can also dampen the effects of market volatility while also potentially adding to total return potential.
Portfolio diversification is not only based on ownership of different stocks, but also of different asset classes. Risk assets such as stocks may be diversified with safe haven asset classes such as bonds or high-quality corporate debt instruments. Investors may also add diversity through the ownership of hard asset classes, including gold, silver or other metals as well as various commodities including crude oil, grains and even lumber.
Although the world of options investing may seem overly complicated to some, they are actually fairly simple financial tools that may be used in several different ways depending on the user’s objectives. A put option provides the buyer the right, but not the obligation, to take a short position in the market for which the put is purchased. A call option is the opposite, providing the buyer with the right, but not the obligation, to take a long position in the market for which it is purchased.
A put option may be used, therefore, to protect a long equity position. If an investor is long a broad variety of S&P 500 stocks, for example, he or she may purchase puts on the S&P 500 index that may increase in value as the index declines. The increase in the value of the put could, then, offset all or some of any decline seen in the investor’s equity portfolio.
Smart, successful investors understand and acknowledge the fact that investing for retirement is a marathon, not a spring. They are often willing, therefore, to give up quick return potential in exchange for more long-term consistent growth with less risk. Knowing that equity markets can and will go through different phases allows investors to plan ahead for the seemingly inevitable downturns that markets may go through. Protecting your portfolio does not need to be costly, either. A strong, well-diversified portfolio that is balanced frequently can withstand a lot of market pain and may pay strong dividends over the investor’s lifetime. Likewise, a portfolio that is hedged using put options can also withstand a great deal of market volatility and downside and may even assist the investor in turning a profit during tough market periods.