The investment profession has come up with countless questionnaires to help investors determine their risk tolerance, but it basically boils down to the fact that investors love to make money, and hate to lose it, in the market. What is needed in regards to stocks is a long-term perspective because short-term market movements can be quite volatile. Furthermore, stock markets have been unusually volatile since the credit crisis, over fears of a double-dip recession and higher government regulation in the markets. And since May, volatility has again increased.
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There are a couple of general ways to try and protect against market volatility over the short term, but there is really only one way to ensure against loss. Below is a more specific overview of these strategies and how they are likely to help protect investors for the remainder of 2011 and beyond.
1. Blue Chips
The stocks of large companies have been unpopular for more than a decade now. As a result, stock market indexes, including the popular S&P 500, haven't returned much over the past 10 years for investors. However, this is due mostly to the fact that large companies traded at unreasonable valuations back in 2000, just before the dotcom bubble officially burst. Running through some of the best known blue chips, Johnson & Johnson traded at about 40-times earnings, Wal-Mart and Walgreen traded close to 50-times, and tech giants Microsoft and Cisco traded at 70-times and 99-times, respectively.
Yet, over the past decade, annual sales growth for the above group has averaged close to 10% annually while profits have grown in the low double digits, meaning the fundamentals have been quite solid. And since the stock prices haven't moved much, they now trade at very reasonable earnings multiples, and most have decent dividend yields. Overall, the growth prospects of blue-chip stocks in general are still compelling, and they should start providing decent gains for investors once the stocks start to follow fundamentals again. Given their reasonable valuations, they also offer downside protection, as compared to other stocks. (For more, see What Are A Stock's Fundamentals?)
A relatively simple investment strategy is to limit investment losses by using a stop-loss order. This is simply setting a predetermined price to sell a stock at, such as 10% below the original purchase price. It can also be adjusted as a stock price rises so as to again limit losses but also lock in gains as the stop-loss is set above the original purchase price but slightly below the price at which the stock is currently trading.
This strategy may not work well in volatile markets, as it can result in the stop-loss orders being triggered often, and can also result in realizing capital gains or losses when continuing to hold keeps any gains or losses unrealized. However, it can help on the fringes and could be employed by investors seeking to offset some downside risk. (For more, see The Stop-Loss Order- Make Sure You Use It.)
3. Puts Orders
In similar fashion to stop-loss orders, a put order can help offset investor fears that a certain stock or market in general is due for a fall. A put gives an investor the right, but not the obligation, to sell a stock at a certain price in the future. There are certain differences between a stop-loss order and put. A stop-loss order may not go through when there is a gap in a stock price, which can happen when a stock stops trading due to a big news announcement and it opens at a materially higher or lower price from where it originally traded. (For related reading, see Introduction To Put Writing.)
Stock markets have been unusually volatile since the financial crisis, but the truth is that markets have always been volatile because there is no sure-fire way to predict the future. Given this inherent uncertainty, there are ways to try and take advantage of market volatility. This can be through buying or selling a security that is based off of market volatility, such as a volatility index known as VIX. A general strategy is to buy it during times of low volatility, which is when the VIX will trade at a low price, and hold it on the expectation that volatility will increase, at which point the VIX will trade up and it can be sold for a gain from the original investment. (For related reading, see Using The VIX For Shorting.)
Cold, hard cash is one of the surest ways to ensure principal protection over the short term. The long-term problem is that inflation eats away at the purchasing power of cash over time. Investments, including bonds and stocks, help protect against inflation, and returns above inflation levels can leave investors with positive real returns. Of course, this creates the risk of further losses, so from this standpoint cash is one of the easiest ways to avoid the risk of larger losses.
The Bottom Line
Investors with a long-term horizon and bias toward investing should view beaten down blue-chip stocks as a way to help protect from near-term downside and leave the potential for positive real returns over the long haul. Of course, this strategy could still be volatile, as stocks are one of the more risky investments over shorter time periods. Stop-loss and put orders are ways to try and offset this short-term risk, but for those that can't stomach any market volatility, cash may be the best answer, at least for now. (Contrarian investors find value in the worst market conditions. For more, see Buy When There's Blood In The Streets.)