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Three Ways to Blunt the Pain of a Stock Market Downturn

Aug. 25, 2014
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By Laurie Itkin

Learn more about Laurie on NerdWallet’s Ask an Advisor

Did you really think the bull market of 2013 could last forever? Recently, those rose-colored glasses might have been knocked off.  But does your portfolio allocation reflect that?

If the majority of your money is invested in U.S. stocks (or ETFs or mutual funds composed of U.S. stocks), you might want to consider one of these three strategies:

  1. Reallocate.  Sell some stocks or funds that have gone up a lot and invest the proceeds in a diversified portfolio of various asset classes. Depending on your time horizon and risk tolerance, these could include some combination of international developed country stocks, emerging market stocks, REITs, commodities and bonds. If you can’t bear to sell most of your holdings due to capital gains tax implications, then consider the next two strategies.
  2. Buy insurance.  A quick and easy way to hedge your portfolio against a market downturn is to buy put options on a major market index such as the S&P 500. If the market corrects, the value of your put options should partially offset the loss of the equities in your portfolio. If the market stays high, you simply lose what you paid for the insurance.  It’s like owning insurance on your home, where you pay a premium to protect the value of your asset.
  3. Generate income from your stock.  Many people shift to dividend-payers when they fear a market downturn because of the ability to collect dividend income while waiting for the market to improve. In addition to receiving dividend income, you can also receive option premium income by writing covered calls on stocks or ETFs you already own. In exchange for agreeing to sell your securities at a certain price sometime in the future, you receive income in your account today. The income you generate with this strategy serves to partially or fully offset declining stock prices.

The default option—doing nothing to adjust to a changing market environment—is to stick with the “buy and hold” strategy, which will likely bear fruit over the long term. But if you don’t want to suffer significant losses in the short term, it might be worth your while to execute a different strategy.