By Peter Mastrantuono
Last week we discussed five ways to enhance your portfolio’s recovery from March’s sharp declines. This week, in Part Two, we outline five strategies to protect against losses that may come with a future market downturn.
5 Strategies to Protect Against Market Losses
- Limit downside risk while maintaining stock market exposure through a market-linked CD. Rather than paying a set interest rate like a conventional bank certificate of deposit, rates on market-linked CDs pay a rate tied to the performance of an index or basket of securities (e.g., S&P 500). The return you receive will depend upon how the underlying index performs and the participation rate of the CD. For instance, if the S&P 500 gains 10% and the CD offers a participation rate of 90%, you will earn 9%. Different CDs may have different conditions, like limiting the upside of what you can earn or whether you receive a guaranteed minimum rate of return. In any case, you will receive at least 100% of your principal back at maturity, subject to the credit risk of the issuing bank and FDIC limits.
- Purchase puts: You can buy puts against individual stock positions (or against an overall equity portfolio). A put option gives you the right to sell a stock at the option’s strike price at any time prior to its expiration date. The premium you pay is a form of insurance that limits downside risk while maintaining the stock’s full upside potential.
- Consider an equity collar: If you have a large stock holding in an employee stock incentive plan (or 401k) and do not want to, or cannot reduce, your position, you may consider executing a simultaneous purchase of an out-of-the-money put option and sale of an out-of-the-money call option with the same expiration dates. This will limit downside risk, but may cap upside potential.
- Rebalance Your Fixed Income Portfolio: With yields at historical lows and widened credit spreads, you may find that your exposure to lower rated bonds and interest rate risk is less appropriate for the current fixed income environment. Reallocating along the credit rating and interest rate curve may help lower the risk of your overall bond portfolio.
- Look to Treasury Inflation-Protected Securities (TIPS). TIPS are adjusted at maturity to reflect inflation and pay a variable rate. Though it’s been a long while since inflation and interest rates have risen in any sustained way., TIPS are an ideal investment for investors who believe that interest rates will rise from these levels and inflation will accelerate over the next several years.
The most appropriate portfolio protection strategies will depend upon your individual circumstances and investment objectives. In developing the right strategy consider how an experienced financial advisor can help you develop a risk management strategy that works for you.
Peter Mastrantuono is a contributing writer to MyPerfectFinancialAdvisor, the premier matchmaker between investors and advisors. Peter worked for over 30 years in the wealth management industry, focusing on retirement planning, investing, asset allocation and financial planning.