Starting with a gut-wrenching plunge on the first trading day of the year, stocks have given investors one frightening day after another in recent weeks. It’s enough to shake the confidence of even the most cool-headed buy-and-hold investor.
If only you could buy an insurance policy that would pay off if stocks go over a cliff.
Actually, you can. By purchasing a type of stock option called a put, you can lock in the right to sell your shares at today’s price no matter how far prices fall. That’s just one of a number of ways to protect against losses, or to minimize them – and investors are wiseto know how each works.
“While weathering the storm is likely the best strategy, ongoing liquidity needs and inability to stomach paper losses make this a difficult strategy to implement,” says Karan Sood, CEO of Vest Financial in McLean, Virginia. “What is required is a consistent risk management strategy that contains the volatility at all times.”
Weathering the storm is the most common risk-control strategy, since the broad market always eventually recovers from downturns. That’s why experts typically say investors should plan on holding their stocks and stock funds for at least five years.
But although the broad market has a great record of recoveries, individual stocks and funds can be wiped out. That’s where the second-most common strategy comes in – diversification.
“For those panicky clients, and anyone we meet with for that matter, the message is always the same – diversification among key asset classes and rebalancing are the ways to minimize market volatility,” says Betsy Vallone, partner in Essential Asset Management of Norwell, Massachusetts. Rebalancing means restoring the intended mix of assets after the price changes get the portfolio off target.
Stocks tend to be among the riskiest of holdings, but tend to provide the biggest returns over time. Bonds are less risky and generally less generous, though not always. Cash is safe, but earns almost nothing.
The basic idea is to have uncorrelated holdings, so that when some go down, others go up. Stocks in energy-producing companies, for example, are likely to fall when oil prices drop, as they have recently. But low fuel prices can be good for companies that use lots of energy.
Professional traders constantly bet on these shifting factors, but that takes a lot of knowledge, effort and stomach for risk. Small investors are usually told to own a wide variety of stocks, so that some will do well while others are in trouble. This can be done quite easily by holding mutual funds that contain many stocks of different types.
Other loss-control techniques are more complex, and although useful in times of high risk, they are often too expensive to employ all the time. Most work best with individual stocks, or with exchange-traded funds and index-style mutual funds such as those that track the Standard & Poor’s 500 index. Your broker can walk you through the steps.
Purchasing puts. As mentioned, these are stock options that allow their owner to sell a set number of shares at a given price anytime over a period of days, weeks or months. If you bought a put to sell 100 shares of XYZ Corp. at $10 a share, you could sell for $10 anytime until the option expired, even if the price fell to $5, $2 or zero. You could then buy the shares back at a cheaper price, or sit on the cash until the smoke cleared. Your stocks would be bought by the person who sold you the put.
Unfortunately, the “premium” you’d pay for this option could be sizable, and if you don’t exercise your option by the deadline you lose all you spent on the premium. Earlier this week, it cost nearly $650 to buy a single put contract, good until mid-March, on $18,500 worth of S&P 500 stocks, using an exchange-traded fund called SPDR S&P 500 Trust (ticker: SPY).
While an option’s price changes with market conditions, it’s too expensive to insure an entire portfolio all the time. It would be cheaper, however, to buy partial insurance. If your stock were trading at $10, it would cost much less to buy a put with the right to sell at $8 than at $10. You could still lose $2 a share, but would be protected against an even deeper sell-off.
“This is like very expensive insurance to cover the downside risk of your assets,” says Chase Hinderstein, wealth management specialist at The Wise Investor Group, a unit of Baird.
Selling covered calls. The opposite of a put, a call is an option giving its owner the right to buy a block of shares at a set price for a given period. The person who sells a covered call owns the shares involved – is covered – and agrees to sell them if the owner of the call exercises his right to buy. The buyer pays the seller a premium.
This technique doesn’t protect the call seller from loss if the share price falls. But the premium received helps offset some of that loss. It’s critical to be willing to sell at the strike price specified in the call, as you most likely will have to sell if the price rises above that level.
“Covered calls are so simple that anyone can do them. They are proven to have better returns with less risk and volatility than the buy-and-hold strategy,” says Mike Scanlin, CEO of Born to Sell, a software firm specializing in covered calls.
Use a stop-loss order. With this, you tell your broker to automatically sell certain shares if they fall to a set price, thus protecting you from deeper losses. The risk: if there is no buyer at that price you might end up selling even lower. You can add a limit, so the shares are sold only at a given price or higher, but then you risk not selling at all if prices plunge.
“For our clients with significant positions in a public company, we may set a stop order 5 percent to 10 percent below the current market price to reduce further declines,” Vallone says.
Saving some “dry powder.” This refers to cash kept available for a good investing opportunity. If stocks fall, your cash can be used to buy some bargains, offering gains in a subsequent rebound. But because cash does not earn much, having too much can undermine returns when the market is going up.
“We look at market drops as buying opportunities,” says P. Jeffrey Christakos, an investment expert at Westfield Wealth Management in Westfield, New Jersey, explaining that downturns are welcome if they are temporary.
Dollar-cost averaging. Buying stocks or funds with a set amount of money every month or quarter helps you avoid the temptation to try to spot the market’s peaks and valleys, says Andrew R. Avellan, founder of Philadelphia Wealth Management Co. Also, a given sum, such as $500 a quarter, will buy more shares when prices are down, reducing your average cost per share in a holding accumulated over time. That will maximize your gains and minimize your losses.
“When considering this strategy, investors should consider their ability to continue investing in times of market downturns,” Avellan says. That can be done by setting up automatic investments with a broker, a fund company or a workplace plan, such as a 401(k).
Written by Jeff Brown of U.S. News & World Report
(Source: U.S. News & World Report)