Take the uncertainty of a presidential election year, worldwide economic problems and that the U.S. bull market — now in its seventh year — is long in the tooth, and investors have plenty to worry about. It’s no surprise that the British vote to leave the European Union triggered a selloff.
If only there were a way to have your cake and eat it too — to ratchet up as the market rises while avoiding the downturns. Is there any surefire strategy?
“The answer is no,” says Ryan McGuinness, president of CTR Financial in Lincolnshire, Illinois.
Still, there are ways to minimize losses in a portfolio, and even to profit from a downturn. How do these techniques work?
Choices and costs. To profit from a downturn, an investor can “short” an exchange-traded fund that tracks the broad market, such as SPDR S&P 500 ETF (ticker: SPY). In a short sale, the investor sells shares borrowed from a brokerage, hoping to buy replacements later at a lower price. It’s buy low, sell high, but in reverse order.
[See: 8 Soaring Stocks That Suffered the Big Bounce.]
In a similar strategy, the investor can buy “put” options that provide the right to sell a block of shares, or market basket like the Standard & Poor’s 500 index, at today’s price for a given period, protecting against loss if a downturn occurs before the option expires.
Although these seem great ways to insure a portfolio, most experts say they involve costs that make them too expensive for ordinary investors to do all the time. Professional money managers who use such hedging techniques can do it much more cheaply.
“It is generally much too expensive to buy put options as portfolio insurance. They drag down your returns during regular times and they are far too expensive during bad times,” says Nicole Boyson, associate professor of finance at the D’Amore-McKim School of Business at Northeastern University, referring to variations in the price, or premium, paid for an option.
The cost is a drag on the portfolio all the time, but gets especially high when the market is more volatile and demand for options rises.
Not everyone agrees completely, of course.
Karan Sood, CEO and co-founder of Vest Financial in McLean, Virginia, says it is much cheaper to buy partial protection with options that pay off only after the security has fallen a specified amount, such as 10 percent. The investor, in effect, gets protection from a deeper loss in exchange for giving up some portion of future gains, he says.
“Options can seem complex and difficult to understand,” he says.
Another portfolio-insurance strategy involves “buffered notes,” says Michael Godwin, manager of portfolio strategy at Fragasso Financial Advisors in Pittsburgh. Those allow the investor to receive gains of an underlying index like the S&P 500 up to a ceiling, such as 20 percent, while protecting against loss up to a set amount, such as 10 percent, he says. The investor misses out on any gains above the ceiling.
The issue with many hedging strategies is that, unlike pure insurance, they require lots of market savvy. If you bet wrong and the market rises instead of falling, you can lose much or all of what you invested in the hedge.
“The problem with these scenarios is that it implies that you know, or think you know, the direction of the market,” McGuinness says, adding that studies by Standard & Poor’s show that is very hard to do.
[See: The 10 Best Materials ETFs We Could Dig Up.]
“Over 10 years, more than 80 percent of large-cap fund managers fail to beat the S&P 500,” he says. “(Managers in) other asset classes are worse. The idea that an individual investor is going to beat the market on a consistent basis when the top firms on Wall Street can’t do it is ludicrous.”
The ETF option. To avoid the need to guess where the market is headed, some investors use exchange-traded funds designed to react automatically to the market’s rising or falling trends, operating on autopilot rather than judgment.
Pacer ETFs of Paoli, Pennsylvania, offers four ETFs keyed to large and mid-sized U.S. stocks, the Nasdaq and European markets. Each remains completely invested in the stocks of its underlying index until the index closes below its 200-day moving average for five straight days, when half the assets are switched to cash. After another five days below the moving average, the remaining assets are converted to cash, which is switched back to stocks when the trend turns positive again for five days.
The Pacer Trendpilot 750 ETF (PTLC), which tracks large U.S. stocks, is too new to have a long-term track record, but is down about 0.9 percent this year, while the S&P 500 is up about 4.5 percent, according to Morningstar. At 0.6 percent, its expense ratio is high for an index-style product.
Spread risk and relax. If hedging with exotic products is too tricky, expensive or uncertain for small investors, what’s the alternative?
“There is only one free lunch when it comes to investing,” McGuinness says: “diversification.”
With a carefully chosen mix of different types of stocks, bonds and cash, the investor assumes that when some fall, others will rise.
The other tried-and-true strategy for overcoming losses is patience.
“All declines are temporary,” says Paul Ruedi, CEO of Ruedi Wealth Management in Champaign, Illinois.
While individual stocks can and do fall and never recover, the broad market has always rebounded to new highs. The S&P 500 lost nearly half its value between October 2007 and February 2009, but recovered by April 2011, and it has kept rising with just a few interruptions. It has nearly tripled since that low in 2009.
In the eight major selloffs since 1966, the market has fully recovered in an average of three years and two months, according to brokerage Charles Schwab.
“Small investors really need to just focus on the long-term,” adds Matthew Schwartz, a financial advisor with New Jersey-based International Planning Alliance. “If you are still in the accumulation phase, basic diversification strategies ought to be enough to dampen the worst effects of a normal business cycle. However, if you are going to be pulling money out of your accounts in five years or less, you may want to consider holding some cash or cash equivalents.”
Boyson believes the best way to balance risk and reward is to invest in index funds covering a variety of asset classes such as large and small stocks, and bonds. Index funds’ low fees improve gains and reduce the sting of downturns.
[Read: How 7 Big-Box Retail Stocks Are Faring.]
“I think that for individual investors, most other types of hedging strategies are too costly and not very effective,” she says.
More from U.S. News
11 Ways President Trump’s Tax Plan Could Affect Americans
7 Ways to Tell if a Stock Is a Good Price
How to Protect a Portfolio From Losses originally appeared on usnews.com
