Without a doubt, volatility in the financial markets can be difficult to handle. Behavioral finance suggests that investors fear loss twice as much as they enjoy an equivalent gain. This is the reason many investors’ portfolios trail the market’s return, as they panic during a downturn and liquidate at precisely the wrong moment. Then they fail to participate in the subsequent market recovery.
Fortunately, there are some strategies you can use to help protect your portfolio during uncertain times:
- Buy a protective put
- Favor large, high-quality dividend paying companies
- Be properly diversified
Buy A Protective Put
Buying a protective put option is akin to buying an insurance policy that pays off in the event of a market downturn. As the market declines, the value of the put increases, thereby offsetting some of the losses.
As an example, let’s say you are comfortable with some risk and you understand that equity markets will experience short-term volatility with the expectation of generating satisfactory long-term returns. Additionally, let’s say you can tolerate equity market losses of up to 20%, after that you feel you would panic and sell, in spite of your long-term orientation. In this scenario, you would purchase a put that begins to offset the market losses after a 20% decline.
The two main costs of this strategy are the cost of the put option plus any commissions charged by your broker. The cost of the put option mentioned above would be about 2.5% of the amount you are protecting and the protection would last for approximately one year. To put it another way, if the market returned 10% for the year, your return would be about 7.5%.
High Quality Dividend Paying companies
High quality dividend paying companies tend to perform relatively well during periods of heightened volatility. Investors value these dividend streams during market stress as these companies are typically large, multinational corporations with more stable operations, especially when compared to their smaller, more speculative brethren.
Companies under consideration for investment should have dividend yields of at least 4% and the capacity (and management’s commitment) to grow these dividends over time.
Be Properly Diversified
Proper diversification is considered the only free lunch in investing and is the most effective of all three strategies. Consider that in 2008, the S&P 500 experienced a loss of 38.49%. Compare this to a diversified portfolio consisting of a 60% allocation to the S&P 500 and a 40% allocation to the aggregate bond index and the loss is reduced to approximately 20%. While a loss of 20% does not seem like much to celebrate, you can see the power of diversification in this example. The value of the bonds, most notably longer dated U.S. treasuries, rose considerably during this period, offsetting the steep drop in the S&P 500.
All three strategies are powerful ways to combat market volatility. Be sure to consult with your investment advisor regarding your personal circumstances.
Legal Disclaimer Past performance is not indicative of future results, for informational purposes only. Nothing in this article should be construed as investment advice. Mark Cernese & Associates is a Registered Investment Advisor in the state of Pennsylvania.
