8 Common Portfolio Protection Strategies
Photo by Micheile Henderson
Originally Posted On: https://lenpenzo.com/blog/id60022-8-common-portfolio-protection-strategies.html
Investing is one of the greatest ways to grow your wealth. After all, the long-term average yearly return in the stock market has been around 10% — and that’s way better than any savings account! But as we’ve all seen, while the market can sometimes go up a lot more, it can also go down a lot more too. This is why it’s so important to practice proper portfolio protection.
The good news is that by hedging against risks, you can make sure that you’re protected against downturns and bear markets. Here are eight of the best options:
Having a diversified portfolio is the best way to reach your long-term financial goals while minimizing risks. If you don’t diversify, then you’re at the mercy of the market.
For example, let’s say that you have a portfolio that’s made up of only burger restaurant stocks. If it’s announced that there’s a beef safety scare, then the share prices of those restaurant stocks are going to drop; this means that your portfolio is going to go down in value too. But if you counterbalanced your restaurant stocks with grocery store stocks, then only part of your portfolio would be affected. In fact, when restaurant stocks go down, grocery store stocks may very likely go up because consumers would rather cook their own food rather than risk going to a restaurant.
You could even diversify further and invest in companies that have nothing to do with food.
All investors should know about stop-loss order trades; they’re a useful tool to protect you from falling share prices.
A stop-loss order is a pseudo-hard stop designed to protect against large price drops. For example, if you buy shares of Company X for $10, you can put a hard stop at $9. This means that if the share price ever hits $9 or below, the shares will be automatically sold.
You can also utilize a trailing stop, which is different. This kind of trade moves with the price of the stock and it can be set in percentages or dollars. Let’s look at the example above.
Let’s imagine that you set the trailing stop at 10%. If the stock price goes up by $2, the trailing stop will move to $10.80 instead of staying at the original $9. And if the price then goes down to $10.50, your shares would’ve been sold once the price hit $10.80.
Many people view dividend stocks as a combination of investing in stocks and using a long-term savings account because companies that pay good dividends also tend to have fast-growing earnings; they also tend to be less volatile.
4. Put Options
A put option is essentially a bet that a stock price is going to go down. This is not the same as shorting a stock because you have the option to sell at a specific point in time in the future at a certain price.
For example, imagine that you own 100 shares of Company X. The stock price has gone up by 80% since the time you bought it earlier this year and a share is now worth $100. As a way to protect your profits, you can purchase a put option of Company X with a date of expiration set for six months in the future and it has a strike price of $105. It costs you $600 to purchase this option. This allows you to sell all of your shares at $105 before the option expires. But if the price drops to $95, the cost to purchase the put option would’ve gone up a lot. Now, you can sell that option and make a profit while countering the lower stock price.
Physical gold held in your possession is a valuable asset that can provide additional portfolio safety, especially during recessions. Because physical gold is money, gold protects your purchasing power during inflation. Even better, physical gold actually increases your purchasing power in times of deflation.
6. Wealth Management Teams
If you’re a high net worth individual and are looking to grow and protect your investments, it’s important to consider hiring a wealth management team. A competent wealth management team can help you transition into a comfortable retirement while also optimizing your portfolio. The advisors will work closely with you so that you can come up with a plan that fits your financial goals and lifestyle. It’s also an excellent way to minimize your taxes and other costs.
7. Principal-Protected Notes
If you’re worried about losing your principal investment then you should definitely consider using principal-protected notes that come with equity participation rights. These are fixed-income securities, like bonds, and offer you a return on your original investment until the security finally matures.
The main difference between bonds and principal-protected notes is the participation in equity that comes along with the guarantee of the principal investment.
For example, let’s imagine that you intend to purchase $1000 in principal-protected notes that are related to the Dow; these notes are set to mature in five years. The issuer of the notes would purchase zero-coupon bonds at a discount value.
These bonds are set to mature at around the same time as the principal-protected notes. These bonds won’t pay any interest until they mature, at which point they’ll be redeemed at their face value. In our example, the $1000 in zero-coupon bonds are purchased for the price of $800.
The $200 that are left will be invested in Dow call options. The bonds would then reach their maturity. Then, profits will be distributed, depending on the participation rate.
If the participation rate is 90%, and the Dow went up by 20% during this time, then you would get back your principal investment of $1000 as well as profits worth $180. You’re not getting $200 because that remainder of $20 is what you pay to guarantee that you get your original investment back.
Now, let’s imagine that over the past five years, the Dow went down by 20%. You’d still get your original investment of $1000 back. If you had invested directly in the Dow, you’d be out $200.
Before investing in these be sure you understand the bank that is guaranteeing the note; if it were to go under, you may be in trouble. You also need to be aware of any fees that come with buying the note.
Compared to stocks, bonds have historically been a low risk way to help you preserve your principal. This is why as most investors get closer to retirement they tend to shift a majority of their portfolio from stocks to bonds for protection. Bonds also offer investors different tax advantages. For example, municipal bonds come with tax-free interest on the federal level. And if your municipal bond is issued by your state, then it’s tax-free on the state level too. The income that you get from US Treasuries is also tax-free on the local and state levels.
The Importance Of Portfolio Protection Strategies
When the market is hot, investors don’t often think about portfolio protection. Unfortunately, when it’s time to start thinking about these strategies, it’s often too late. But by having protective measures in place, you can make sure that major losses to your investments and wealth are minimized.