The key to successful long-term investing is the preservation of capital. Warren Buffett, arguably the world's greatest investor, has one rule when investing - never lose money. This doesn't mean you should sell your investment holdings the moment they enter losing territory, but you should remain keenly aware of your portfolio and the losses you're willing to endure in an effort to increase your wealth. While it's impossible to avoid risk entirely when investing in the markets, these five strategies can help protect your portfolio.
TUTORIAL: Basic Financial Concepts
One of the cornerstones of Modern Portfolio Theory (MPT) is diversification. In a market downturn, MPT disciples believe a well-diversified portfolio will outperform a concentrated one. Investors create deeper and more broadly diversified portfolios by owning a large number of investments in more than one asset class, thus reducing unsystematic risk. This is the risk that comes with investing in a particular company as opposed to systematic risk, which is the risk associated with investing in the markets generally.
According to some financial experts, stock portfolios that include 12, 18 or even 30 stocks can eliminate most, if not all, unsystematic risk. Unfortunately, systematic risk is always present and can't be diversified away. However, by adding non-correlating asset classes such as bonds, commodities, currencies and real estate to a group of stocks, the end-result is often lower volatility and reduced systematic risk due to the fact that non-correlating assets react differently to changes in the markets compared to stocks; when one asset is down, another is up.
Ultimately, the use of non-correlating assets eliminates the highs and lows in performance, providing more balanced returns. At least that's the theory. In recent years, however, evidence suggests that assets that were once non-correlating now mimic each other, thereby reducing the strategy's effectiveness. (See why investors today still follow this old set of principles that reduce risk and increase returns through diversification. Check out Modern Portfolio Theory: Why It's Still Hip.)
Leap Puts and Other Option Strategies
Between 1926 and 2009, the S&P 500 declined 24 out of 84 years, or more than 25% of the time. Investors generally protect upside gains by taking profits off the table. Sometimes this is a wise choice. However, it's often the case that winning stocks are simply taking a rest before continuing higher. In this instance, you don't want to sell but you do want to lock-in some of your gains. How does one do this?
There are several methods available. The most common is to buy put options, which is a bet that the underlying stock will go down in price. Different from shorting stock, the put gives you the option to sell at a certain price at a specific point in the future. For example, let's assume you own 100 shares of Company A and it has risen by 80% in a single year and trades at $100. You're convinced that its future is excellent but that the stock has risen too quickly and likely will decline in value in the near term. To protect your profits, you buy one put option of Company A with an expiration date six months in the future at a strike price of $105, or slightly in the money. The cost to buy this option is $600 or $6 per share, which gives you the right to sell 100 shares of Company A at $105 sometime prior to its expiry in six months. If the stock drops to $90, the cost to buy the put option will have risen significantly. At this point, you sell the option for a profit to offset the decline in the stock price. Investors looking for longer-term protection can buy long-term equity anticipation securities (LEAPS) with terms as long as three years. (Learn more in Long-Term Equity Anticipation Securities: When To Take The "LEAP"?)
It's important to remember that you're not necessarily trying to make money off the options but are instead trying to ensure your unrealized profits don't become losses. Investors interested in protecting their entire portfolios instead of a particular stock can buy index LEAPS that work in the same manner.
Stop losses protect against falling share prices. Hard stops involve triggering the sale of a stock at a fixed price that doesn't change. For example, when you buy Company A's stock for $10 per share with a hard stop of $8, the stock is automatically sold if the price drops to $8.
A trailing stop is different in that it moves with the stock price and can be set in terms of dollars or percentages. Using the previous example, let's suppose you set a trailing stop of 10%. If the stock goes up $2, the trailing stop will move from the original $9 to $10.80. If the stock then drops to $10.50, using a hard stop of $9, you will still own the stock. In the case of the trailing stop, your shares will be sold at $10.80. What happens next determines which is more advantageous. If the stock price then drops to $9 from $10.50, the trailing stop is the winner. However, if it moves up to $15, the hard stop is the better call.
Proponents of stop losses believe that they protect you from rapidly changing markets. Opponents suggest that both hard and trailing stops make temporary losses permanent. It's for this reason that stops of any kind need to be well planned. (A stop loss is a simple but powerful tool to help you implement your stock-investment strategy. Find out how; see The Stop-Loss Order - Make Sure You Use It.)
Investing in dividend-paying stocks is probably the least known way to protect your portfolio. Historically, dividends account for a significant portion of a stock's total return. In some cases, it can represent the entire amount. Owning stable companies that pay dividends is a proven method for delivering above-average returns. When markets are declining, the cushion dividends provide is important to risk-averse investors and usually results in lower volatility. In addition to the investment income, studies show that companies that pay generous dividends tend to grow earnings faster than those that don't. Faster growth often leads to higher share prices which, in turn, generates higher capital gains.
In addition to providing a cushion when stock prices are falling, dividends are a good hedge against inflation. By investing in blue chip companies that both pay dividends and possess pricing power, you provide your portfolio with protection that fixed income investments, with the exception of Treasury inflation-protected securities (TIPS), can't match. Furthermore, if you invest in "dividend aristocrats", those companies that have been increasing dividends for 25 consecutive years, you can be virtually certain that these companies will up the yearly payout while bond payouts remain the same. If you are nearing retirement, the last thing you need is a period of high inflation to destroy your purchasing power. (For more insight, read Why Dividends Matter.)
Investors who are worried about protecting their principal might want to consider principal-protected notes with equity participation rights. They are similar to bonds in that your principal is usually protected if you hold the investment until maturity. However, where they differ is the equity participation that exists alongside the guarantee of principal.
For example, let's say you wanted to buy $1,000 in principal-protected notes tied to the S&P 500. These notes will mature in five years. The issuer would buy zero coupon bonds that are maturing around the same time as the notes at a discount to face value. The bonds would pay no interest until maturity when they are redeemed at face value. In this example, the $1,000 in zero-coupon bonds is purchased for $800, and the remaining $200 is invested in S&P 500 call options.
The bonds would mature and, depending on the participation rate, profits would be distributed at maturity. If the index gained 20% over this period and the participation rate is 90%, you would receive your original investment of $1,000 plus $180 in profits. If it loses 20%, you would still receive your original investment of $1,000 while a direct investment in the index would lose $200. You are forfeiting $20 in profits in return for the guarantee of principal.
Risk-averse investors will find principal-protected notes attractive. Before jumping on board, however, it's important to determine the strength of the bank guaranteeing the principal, the underlying investment of the notes and the fees associated with buying them. (To learn more about principal protected notes, check out Principal-Protected Notes: Hedge Funds For Everyday Investors.)
The Bottom Line
Each of the five strategies described herein can help you protect your portfolio from the inevitable volatility that exists when investing in stocks and bonds. Choosing between them is depends on your individual financial situation.