3 Strategies to Minimize Downside Risk (Looking for More Ideas)

ValueStocks asked me on twitter (if you’re on twitter, be sure to follow ModernGraham for some insightful comments) what I like to do to protect from the market downside when the market seems overbought (like now).  It got me thinking – what are some techniques to use when protecting against downside risk?  I came up with a couple that I’ve outlined here, split between long-term strategies and short-term strategies.  What do you like to do?  Please comment below and I’ll put together a list of responses for next week.

Long-Term – defined as the market hitting all-time highs.  An example would be during the late-90s and again around 2006-2007.

  • My main strategy in long-term situations would be to look at bonds as a very attractive alternative to equities.  This path is getting easier as ETFs become more popular.  The fund that I like the most is the iShares Barclays 10-20 yr Treasury Bond ETF (TLH).  This fund mimics the performance of a portfolio of 10-20 year Treasury Bonds.  The yield on the fund is currently 3.91%, and in general the yield moves inversely to the S&P 500.  In this latest rise in the market, the yield has moved from approximately 3.7% at the end of March to the current 3.91%.  In the meantime, the S&P 500 went from 797.87 to 970.13.  As many of you know, the price of a bond will move inversely to its yield.  That is always a concern when you’re looking at investing in a bond fund.  From March 31 to today, the price of TLH has gone from 117.25 to 106.89.

    I consider a switch to bonds to be a little bit of a more long-term strategy, as fluctuations within a market can be a bit difficult to trade due to transaction costs.  So it is worth looking at TLH’s performance long-term.  In this case, the fund is relatively new, and we can’t track the full bear market (we can only look at July of 2008 onwards as opposed to October 2007).  However, TLH did perform well during the period, moving inversely to the S&P 500, though it was not a perfect inverse relationship.  As a result of the strong performance of the price of the fund in addition to the yield, I would strongly recommend the long-term strategy of moving to bonds when equities are hitting all-time highs.

Short-Term – defined as quick swings in the market within a 3-month period.  An example is the movement we’ve seen recently.

  • One of my strategies to protect against downside market risk in the short-term is to rebalance your portfolio fairly regularly.  I rebalance my personal portfolio about once every 3 months.  As a result, any gains I see in one asset that is inconsistent from the portfolio as a whole will be moved to the investment assets that have not gained as much – likely those that are going to see higher gains in the future.
  • Another short-term strategy is the one that ValueStocks suggested on twitter, and that is to buy Put Options on the index funds.  While this is a strong strategy because it guarantees that any downswings will be covered by the put option (like insurance), it could end up costing some of the gains of the portfolio.  For example, when  you buy a put option you must pay to purchase the option.  If the price of the underlying asset does not fall prior to the exercise date, you are out your purchase cost.  Contrast that to the bond fund strategy I mentioned above.  When you buy bonds, you may see downside on the bond if the stocks continue to rise, but at least you are getting a yield on the bonds.

What are some strategies that you like to employ in the short- or long-term to minimize downside risk?


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