|August 26, 2015
4 Steps To Protect Your
Portfolio In A Downturn
By Amy Calistri
The last couple of weeks haven't been kind to investors. The S&P 500 Index is down more than 9% since August 10 and every trading day has been filled with drama.
What started as China's central bank devaluing its currency -- the yuan -- has morphed into uncertainty about the strength of the global economy. And the one thing that the market hates is uncertainty.
It's not easy to make decisions and take action in a pessimistic and uncertain market. But it's often the tough decisions that allow us to sleep better at night. Here are some of the things I focus on in times like this...
Evaluate Your Cash Balance
As investors, we have been made to feel guilty about holding cash. It's as if we're shirking our responsibilities. We feel like we should always have our entire portfolio working for us. But cash does work for us.
Cash holds up pretty darn well in a downturn. Cash helps us sleep better at night, no matter what the market throws at us. Cash allows us to buy shares of great companies during a downturn, without having to liquidate another position.
It's advantageous to build up a cash buffer when the market is rallying and you need it least. But even a volatile market will provide opportunities to take some investments off the table.
Consider A Short Index Fund For Protection
If you have been diligent about maintaining your portfolio, then it should contain fundamentally-sound securities that have a good probability of beating the market. But in a downturn, beating the market may be cold comfort. Instead of selling quality holdings -- or risking their sale with a stop loss order -- you may want to protect your portfolio with a short index fund.
These funds track the inverse of their underlying indexes. For instance, in a down market a short S&P 500 fund should theoretically gain the same percentage that the S&P 500 loses. For larger downside protection there are also leveraged short index funds. Leveraged short, or "ultra-short" funds, are designed to move two or three times the inverse of an index. Some examples of short index ETFs offered by ProShares are:
ProShares Short S&P 500 (NYSE: SH)
ProShares Short QQQ (NYSE: PSQ)
ProShares Short Dow 30 (NYSE: DOG)
ProShares Short Russell 2000 (NYSE: RWM)
Funds like these offer good short-term protection. However, inverse and leveraged funds have some drawbacks, especially when held for longer periods.
Use Stop Losses And Trailing Stops Judiciously
Stop loss and trailing stop orders are sell orders that can be used to protect gains and minimize losses on individual holdings. To set up a stop loss, you establish a price below the market price. If the security should drop to or below that price, a sell order will be executed.
Since it's more likely that a sell will be executed in turbulent markets, it's important to ask yourself two important questions before setting up a stop loss or trailing stop:
1) Would you be better off selling the position now rather than risk selling it at lower price later?
2) If you were stopped out of the position, would you be inclined to buy it back in a relatively short period of time?
Stops are good tools that can enforce selling discipline in badly-behaving markets. But they're not a panacea. In turbulent markets, you can create a lot of churn and transaction fees with stop-loss orders. You may also sell at a low or get stopped out of a position you really wanted to hold.
Stops will offer you downside protection. But make sure to ask your "sell now" or "hold" questions before you use them.
Bottom Fish With Limit Orders
It's hard to haggle over something that's in demand. But if there's an oversupply, you have a good chance to find a better deal. As long as there's fear in the market, sellers will be many and buyers will be few. As a buyer, that gives you an opportunity to bid for securities below the market price.
When you find an opportunity that you think is a good one, consider using a limit order, set below the market price. If the price falls from current levels, this order will be there waiting... and a penny saved is a penny earned. Plus, trimming a percent or more off your cost gives you that much more potential to gain.
For example, the domestic economy is relatively strong compared to the rest of the world. And small-cap companies tend to be less dependent on the global economy. So this might be a nice time to bottom fish for a security like the Wisdom Tree U.S. SmallCap Dividend Growth Fund (NYSE: DGRS). It is underweight energy, which makes it less volatile in this environment. And it also pays a modest dividend yield of roughly 2%.
The point of bottom fishing is to reduce your cost basis or initiate a new position at a low price. After all, if you're buying in a riskier market, then you want to be compensated for that risk. So be boldly frugal; set your limit prices well below the market price. If the market rallies, then you won't mind missing out on a few fish. But if it doesn't, then you want the best deal you can get.
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Chief Investment Strategist
The Daily Paycheck