Investors sometimes ask whether they should reduce their stock exposure when uncertainty is rising. The concern might be an upcoming midterm election, escalating geopolitical tensions, worries about government debt, elevated valuations, or simply a known date when the money will be needed. And honestly, these are all valid concerns today.
Rather than selling what you own and attempting to time the market, another approach is to consider buying portfolio “insurance.” Since the 1970’s the industry has developed standardized securities that are extremely liquid that trade through the exchanges providing insurance type protection.
One such security is called a “put option” and in this case, it is sometimes called, a “protective put”, because you are protecting what you own. In the simplest terms, a “put option” gains in value when a security/portfolio drops in value.
This type of protection can be particularly valuable when the timing of a financial need is fixed. If you know you will need $500,000 for a business purchase, home purchase, college expense, or other major obligation one year from now, protecting the portfolio during that specific window may make more sense than simply hoping the market cooperates.
What does this allow you to do?
It allows you to continue to hold your current investments and participate in the upside, nothing changes in terms of what you currently own. What you do, is add to your portfolio, by “buying insurance.” This insurance (using a put option) will now define how much downside protection you have.
The options market provides investors the ability to completely customize the “insurance” to meet their specific needs and/or risk profile. Some investors might be comfortable absorbing the first 8%, 10%, 15%, or even 20% of a market decline, and really just want protection against very large losses. Others might want immediate protection at their current portfolio value. Some investors want protection for only a very short period-of-time, say a few weeks to a few months while other investors may want to go out more than a year. The market offers an almost endless array of options to suit your needs. As you would imagine, the more protection you want and for a longer period of time, the more you will pay.
Surprise, surprise, like any insurance, the protection isn’t free.
For example, a $1M portfolio, of which $650,000 is invested in the S&P 500 or something similar, in today’s current market, a put spread providing protection from roughly 15% to 30% below the market costs about $7,800 for about a year’s worth of insurance is roughly 1.2% of the stock portion of the portfolio. In this case, you still have all the upside that you had prior to purchasing the insurance but now you have limited your downside.
In addition to buying insurance on your entire portfolio or a large portion of it, there is also the ability to just insure a particular holding. For example, if you hold Apple, or Amazon, Johnson & Johnson, or countless other companies, there is the ability to buy insurance on these individual positions.
So, what’s the risk?
If the market rises, the insurance you purchased may expire worthless. Basically, you bought insurance you never used, not unlike homeowners’ insurance or car insurance. But like other types of insurance, it very well may be worth it…knowing that you are protected from the whims of the market.
The goal isn’t to predict the next market decline. It’s to make sure a market decline doesn’t derail your plan.
-Paul R. Rossi, CFA