Value investing comprises several rules while one stands apart: Never Lose Money. It is the most potent investment mantra to help hedge portfolios from market uncertainties, material developments, and crises.
Explore some of the best portfolio protection strategies with us.
Why Do You Need to Protect the Portfolio?
A portfolio is a basket of investment securities and assets, often created following the personal allocations targets of an investor. These targets divide the investible corpus into a pre-defined ratio or percentage.
Broadly, we can segregate every typical portfolio into 3 instruments of investment:
- Debt and
- Liquid assets
The returns generated by a portfolio follow the two-way movement and dwindle because of various factors:
- The asset allocation (the ratio in which you have invested your money across different segments)
- The years of compound growth that your portfolio’s assets will enjoy
- The market developments and the various macroeconomic factors
By adopting adequate measures, techniques, and portfolio protection strategies, every investor can generate excellent returns besides hedging oneself from capital losses.
Top 3 Portfolio Protection Strategies
Let us list the three strategies below.
1. Hedging Through Derivative Contracts
If you are an investor from a non-financial background, the term “derivatives” is enough to resemble rocket science. It might be true, as derivatives are indeed complex. However, every learned investor knows the benefits of hedging through a derivative contract.
It is a necessity, and you must learn this art. Let us address how to protect a portfolio via the Put option.
Using Put Option to Safeguard from Adverse Future Price Movements
Every portfolio comprises stocks, investments in the Equity segments that keep on fluctuating owing to the market forces of demand and supply. If you want to protect your portfolio’s equity stocks from adverse future price movements, you will purchase put options for each.
By doing this, you will get the right to sell your stock (for which you have purchased a put option):
- At a Pre-determined price
- By a pre-determined date
You will never be under any obligation after purchasing a put option, as you buy a right to sell when you pick up a put option.
Still unclear? Let us understand it through this example:
Noah is a conservative stock market investor, and even a random thought of losing money sends chills down her spine. She was bullish on the stocks of ABC Trading Services Inc. She purchased 100 stocks at the rate of $50 per stock.
The stock even performed as per her expectations and has even surged 70% in value. Presently, it is trading at $85 apiece. Noah relies on Bollinger Bands (technical indicator) and expects a correction in the stock price as she contemplates the beginning of a bear phase.
Now, to protect its profits and even secure the overall portfolio returns, Noah purchased a Put option from the market, which has the following features:
- The strike price–is $90
- The purchase cost ($5 per share)–is $400
- The expiration date–is 6 months
By doing this, Noah got the right to sell the same stock for $90 within the next 6-months.
Noah is a seasoned campaigner, and she correctly predicted the bear phase. The stock is now trading at $65 apiece because of a sharp correction in its price.
Noah applies her put option and could sell all of her 100 shares at $95 apiece.
Noah’s Earning Statement (in both scenarios)
|Particulars||Hedging via a Put option||No Hedging|
|Equity Investment (A)||$5,000 (100 stocks * $50 per share)||$5,000 (100 stocks * $50 per share)|
|Selling Price (B)||$9,000 (100 stocks * $90 per share)||$6,500 (100 stocks * $65 per share)|
|Cost of Put Option (C)||$500 (100 stocks * $5 per share)||$0|
|Profit (B – A – C)||$3,500||$1,000|
One can observe from the table above that Noah could enhance her profit by 250% by buying a Put option.
Diversification preserves wealth. Every seasoned investor knows this phrase and uses it practically to safeguard the portfolio from adverse market situations.
Being one of the most effective strategies, if you want to protect your portfolio using the same, then:
- Spread your wealth across the various sectors and industries.
- You must invest an appropriate portion of your income into fixed-income instruments, such as debentures, bonds, fixed deposits, dividend-paying stocks, etc.
- You must invest an appropriate percentage of your investible surplus into gold. Gold and stocks have an inverse relationship.
- If your corpus size is large enough, try to invest an ideal percentage into the real estate.
Undoubtedly, diversification prevents you from cracking all your eggs in a single instance.
Your equity investments might trip, but your gold or real estate investments will not. Similarly, you will witness a rise in the prices of stocks as soon as there is a gold slump.
Real estate is evergreen and will give stability to your portfolio. Fixed income instruments will generate periodic returns for you, and their prices don’t fluctuate that much.
3. Using Stop Losses While Trading
Do a task today. Browse a few portfolios of your friends and colleagues. In eight out of ten cases, you find that there are investments made into equities.
In the words of a famous portfolio developer, “Equity investments are like double-edged swords. If they can multiply your returns and dominate the other assets in your portfolio, in another instance, your overall portfolio returns could go into the red zone.”
Hence, as per a rule of thumb, invest in the stock market using stop losses. Recognize your risk appetite and set an exit point. Follow it and close all your unsuccessful trade deals on breaching this point or price.
For example, you recently added Stock X to your portfolio at $15 per share. You can set a stop loss at $12. If the security price falls or goes below $12, your stock will get sold automatically.
By implementing the stop losses, you are safeguarding yourself from deep losses, protecting your portfolio’s overall return from any severe beating.