Most investors think they can handle market volatility pretty well, but the data shows they tend to be panic sellers.
The recent market uncertainty highlights the need to be more mindful of portfolio risk management.
Here’s how to “keep calm and carry on” by using some portfolio shock absorbers to cushion the blow when markets turn against you.
The Golden Rule: Trailing Stop-Loss
We have all been there: You buy a stock or fund, and it appreciates in value rapidly. Then it stumbles and begins to decline.
What do you do? Should you buy more, let it ride, or sell?
Save yourself a lot of pain and agony by following a simple rule: If a position ever falls more than 25% from its high, sell it immediately and reassess the situation.
Some may counter that this 25% rule is a bit arbitrary, but no doubt a 25% decline from a high is about as much as most investors can handle. This sort of decline also indicates that the fundamentals have broken down and it’s time to pause and revisit a holding.
More risk-averse investors may want to have a tighter stop-loss policy set at 10% to 20%.
Hedging with ETF Put Options
Many ETF investors are unaware that roughly 40% of ETFs have options that can be used to hedge positions. For some ETFs, option maturities go out as far at January 2016.
The easiest way to find out if options are available for a specific ETF is to go to Yahoo Finance and put in the ticker. On the left side will be a menu. Just click on the “Options” link, and if options are available, they will come up for review.
Before jumping into options trading, you should consult with your financial advisor and do some research on the basics. You can keep it simple like checkers or get a bit more sophisticated like chess.
One of the simplest uses of options is to use them to hedge a long ETF position. For example, you could put in place what I refer to as “China insurance.”
Suppose you think Chinese markets (NYSE: FXI) will go up but you are uncomfortable with the downside risk that goes along with investing in China. You could invest in a China ETF like FXI or select some promising Chinese stocks and, at the same time, purchase an FXI put option (right to sell) with an expiration date in January 2015 or 2016. The cost of this is the “premium,” which will depend on what “strike price” you choose.
If your China portfolio or FXI goes up more than the price of this premium, you will make a profit. If it goes the wrong way, your loss will be somewhat offset by the put option in place.
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Cash Can Be King
Many investors have a hard time holding cash in a portfolio. Cash has to be put to work for a portfolio to grow, but it is a lot smarter to do it gradually than to throw it all in the market at once.
Likewise, going 100% cash in your portfolio is almost always a blunder. But in a sharp market downturn when your positions hit their stop limits, let some cash accumulate and then follow a calm plan to put it to work.
As Warren Buffett puts it, when great stocks are on sale, you need to back up the truck of cash rather than use a thimble.
Inverse ETF Hedges
You should also be aware that there are exchange-traded funds (ETFs) that move opposite markets.
For example, if you had a very strong belief that emerging markets were very overvalued, you might consider hedging your positions with the MSCI Emerging Markets Short index (NYSE: EUM), which moves opposite the MSCI Emerging Market index.
There are inverse ETFs out there on a wide range of assets from oil to gold to Treasuries.
Keep calm with these portfolio shock absorbers. They will help you manage portfolio risk and avoid panic selling.
Until next time,
Carl Delfeld for Wealth Daily
