8 Strategies to Protect Your Investments

Bob Powell of The Wall Street Journal’s MarketWatch, noting that some people are getting nervous now that the S&P 500 has hit a four-year high, offers eight strategies for protecting your portfolio.  His article opens with Dave’s critique of portfolio insurance:

To be fair, however, not all advisers are fond of this approach. “There are certainly techniques known as ‘portfolio insurance’ that employ the use of different kinds of options—buying and selling index options can be used to minimize the downside risk of a diversified portfolio,” said Dave Yeske, a managing director of Yeske Buie. “But we believe these techniques are too expensive and don’t add value in the long run.”

According to Yeske, the very use of the term portfolio “insurance” is a bit of a misnomer. “This is not insurance in the same sense as life insurance or homeowners insurance,” Yeske said. “These kinds of insurance protect you from irrevocable loss. A human being who dies prematurely does not rise from the dead. A house that burns down does not spontaneously rebuild itself. A portfolio, on the other hand, will rebuild itself after a cyclical downturn.”

Buying options as “insurance” represents an expense, not an investment, said Yeske. “Options, after all, are a wasting asset and a zero-sum game,” Yeske said. “Better to build resilience into your portfolio in other ways, like allocating an adequate amount to cash and short-duration, high-quality bonds. Any loss in return potential from owning cash and bonds will be less than the cost of ‘insurance’ and will allow you to leave your equities unmolested during a cyclical downturn.”

Still, there are times when Yeske uses portfolio insurance. “For example, when a client holds a large, undiversified position in restricted employer stock, we will use options to protect this client from the short-term downside risk they face until the restrictions are lifted and they can liquidate the position in favor of a more diversified portfolio,” he said.

You can find an extended explanation of how portfolio insurance works and why we rarely recommend it in our webinar: Economic Vomatility and Financial Planning Dramamine.