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2 Portfolio Protection Strategies That Don’t Work — and 2 That Do

April 25, 2016
Investing, Investing Strategy
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By Geoffrey Zimmerman, CFP

Learn more about Geoffrey on NerdWallet’s Ask An Advisor

Since the start of the year, the stock market has been swinging wildly, and some investors may be willing to try just about anything to protect their portfolios, including strategies that don’t often work.

Two common portfolio protection strategies — stop-loss and put options — aren’t as good at protecting your capital and maximizing your earnings as the simple methods of diversification and rebalancing.

Stop using stop-loss

A stop-loss order is a standing order to sell a particular security (such as individual stocks and exchange-traded products, not open-end mutual funds) when it drops in price by a certain percentage. It may temporarily stop the bleeding when the market is swinging down, but can do more harm than good to long-term portfolio performance.

For instance, say you own 100 shares of Company X, trading at $100 per share. Worried about a market decline, you put in a standing stop-loss order to sell if the price drops by 10% (to $90 per share). A month later, the stock drops to $90 during trading hours; your broker dutifully sells your shares. With the leftover funds, you purchase Company Y stocks at $90 a share and place a stop-loss order to sell at $81 (10% below your purchase price).

During the night when the markets are closed, a dictator in a country halfway around the world sneezes, and the market reacts. The next morning, Company Y’s opening trading price is $70 because of the large volume of sell orders that flooded in overnight. Because of the way stop-loss orders work, you sell at $70, the next available market price once your order is triggered, instead of getting out at $81 as you thought you would. Your losses have surpassed 10%, and you’ve incurred additional trading costs.

You are sitting on a diminishing, but still tidy, sum of cash to invest. However, concerned by your losses, you now want to wait until the market looks like it’s going up before you buy back in. But it’s virtually impossible to consistently predict which direction the market will go, and by waiting until after the market is going up, you’ll have missed out on potential gains.

Ultimately, a stop-loss strategy defeats sound investment principles by creating additional trading costs when the stops are triggered and by relying on market-timing decisions, which are notoriously unreliable.

Put aside put options

Another common portfolio protection tool that tends to disappoint in the long run is a put option. In exchange for an upfront fee, the writer of the option agrees to purchase your stock at a predetermined price during the life of the contract.

With a put option, you are purchasing a contract that gives you the right (not the obligation) to sell your stock at a specific price, no matter what happens to the actual price of the stock. Note that this is different from the stop-loss strategy in which you have a standing order to sell the stock once it falls below a predetermined price that is lower than the market price.

For example, let’s suppose it’s May 1 and you own 100 shares of XYZ Co., which is trading at $100 per share, and you are worried about a potential price drop. For a fee of $300, you can purchase a contract that will allow you to sell your 100 shares of XYZ Co. to a purchaser for $100 per share on or before May 31, no matter what the price of XYZ stock does between now and May 31. If the stock price goes up, you keep your shares, but lose the $300 for the contract. If the price goes down (even if it goes to zero), you sell your shares and pocket the $100 per share (minus the $300).

The primary issue with this strategy is the cost of buying the put options. When market volatility increases, the premiums for the put options also increase. Over time, in order to not lose capital, the portfolio will need to grow by enough to offset the cost of the options. Although this hedging strategy may offer some short-term comfort, ultimately the costs erode long-term returns.

Diversification and rebalancing

Investors use stop-loss orders and put options to help protect themselves from short-term market risk and potential loss of capital. But the strategies themselves involve problematic and potentially costly issues. So if stop-loss and put options are off the table, how can you protect your portfolio in a volatile market? Investors should use the same tactics that work in any market, calm or volatile: Build a diversified portfolio and periodically rebalance it.

Building a diversified portfolio involves selecting a mix of investments by type (such as stocks, bonds, cash or commodities) from a variety of industries and from across the globe. The proportion of investments (for instance, 60% stocks and 40% bonds) is determined based on the investor’s desired level of risk and return. Historically, stocks tend to be more risky but yield greater returns than bonds, so a portfolio with a greater stock allocation would be suitable for a more aggressive investor. The overall performance of the portfolio in any given year will depend on the proportionate contribution from each of its components.

Rebalancing refers to periodically buying or selling investments when market movement causes the portfolio to drift away from the initial target allocation. Investors purchase investments when the price relative to their starting point is lower (buy “low”), and they sell investments after an increase in price (sell “high”). By using this type of disciplined approach, investors can maximize their earnings and make the most of market conditions.

A caveat, however: The very act of rebalancing involves trimming “winners” and adding “losers,” which can sometimes be difficult to do for self-guided investors who are emotionally (and not just financially) invested in their portfolios. If this is the case for you, consider working with an independent advisor who can help you set aside emotion and make the necessary adjustments to continue protecting your portfolio.

Balance and endurance

By using a disciplined approach of rebalancing, you are adding to investments when prices are lower, as opposed to the stop-loss approach, which involves selling an investment when the stock price falls. Periodic rebalancing does not require market timing or attempting to guess which way the markets might move in the near future. It does involve the placing of trades and thus the associated costs (trading fees and possibly taxes), though less frequently than with stop-losses.

History and investor experience have consistently shown that success in investing is ultimately about balance and endurance. To that end, diversification and periodic rebalancing are the best portfolio protection tools for long-term investors.

Geoffrey M. Zimmerman, CFP, is a senior advisor and chief compliance officer with Mosaic Financial Partners.