6 common investment portfolio protection strategies

Warren Buffett, arguably the greatest stock picker in the world, has a rule when investing: never lose money.

This does not mean that you should sell your investment the moment they start moving south. But you should be keenly aware of their movements and the losses you are willing to bear. Although we all want our assets to be fruitful and multiply, the key to long-term investment success is to retain capital. Although it is impossible to completely avoid risks when investing in the market, these six strategies can help protect your investment portfolio.

Key points

  • The basic principle of investment is: protect and preserve your principal.
  • Capital preservation techniques include diversifying the holdings of different asset classes and selecting unrelated assets (that is, they are inversely proportional to each other).
  • When the price of your investment starts to fall, put options and stop loss orders can stop the bleeding.
  • Support your investment portfolio with dividends by increasing your overall return.
  • Capital-guaranteed notes can protect investments in fixed-income instruments.

1. Diversity

One of the cornerstones of modern portfolio theory (MPT) is diversification.In the context of a market downturn, MPT believers believe that a highly diversified portfolio will be better than a concentrated portfolio. Investors create deeper and broader portfolios by having large investments in more than one asset class, thereby reducing non-systematic risks.This is the risk of investing in a particular company. Some financial experts say that a stock portfolio of 12, 18, or even 30 stocks can eliminate most, if not all, non-systematic risks.

2. Non-related assets

The opposite of unsystematic risk is systemic risk, which is the risk associated with general market investment. Unfortunately, systemic risks always exist. However, there is a way to reduce it by adding unrelated asset classes (such as bonds, commodities, currencies, and real estate) to the stocks in your portfolio.Compared with stocks, non-correlated assets react differently to market changes—in fact, they usually move in the opposite way. When one asset falls, another asset rises. Therefore, they can eliminate fluctuations in the overall value of your investment portfolio.

Ultimately, the use of non-related assets eliminates the ups and downs of performance and provides a more balanced return. At least this is theory.

In recent years, this strategy has become more difficult to implement. After the 2008 financial crisis, assets that were once unrelated now tend to imitate each other and respond to the stock market simultaneously.

3. Put options

From 1926 to 2009, the Standard & Poor’s 500 Index fell in 24 of 84 years, or more than 25% of the time. Investors usually protect upward gains through profit-taking. Sometimes this is a wise choice. However, usually, the winning stocks just take a break before continuing to move higher. In this case, you don’t want to sell, but you do want to lock in some gains. How do i do this?

There are several methods available. The most common is to buy put options, which is a bet that the price of the underlying stock will fall.Unlike short stocks, put options allow you to choose to sell at a specific price at a specific point in the future.

For example, suppose you own 100 shares of company A. The stock has risen by 80% in one year and is now trading at $100. You are sure that its future is very good, but the stock rises too fast and may fall in the short term. In order to protect your profits, you purchased a put option from Company A at a strike price of $105 or a price slightly lower than the capital, and the expiration date is six months in the future. The cost of purchasing this option is $600 or $6 per share, which gives you the right to sell 100 shares of Company A at a price of $105 sometime before expiration six months.

If the stock drops to $90, the cost of buying put options will rise sharply. At this point, you sell options to gain profits to offset the decline in stock prices. Investors seeking long-term protection can purchase long-term equity prospective securities (LEAPS) with a maturity of up to three years.

It is important to remember that you don’t have to make money through options, but to work hard to ensure that unrealized profits do not turn into losses. Investors interested in protecting the entire portfolio rather than specific stocks can purchase the index LEAPS that operates in the same way.

4. Stop Loss

Stop loss orders can prevent the stock price from falling.You can use many types of stops. A hard stop loss involves triggering the sale of a stock at a constant fixed price. For example, when you buy company A’s stock at a price of $10 per share and the hard stop loss is $9, if the price drops to $9, the stock will be automatically sold.

The difference between trailing stop loss is that it moves with the stock price and can be set in dollars or percentages. Using the previous example, suppose you set a trailing stop loss of 10%. If the stock appreciates by $2, the trailing stop loss will rise from the original $9 to $10.80. If the stock subsequently drops to $10.50, using a hard stop loss of $9, you will still own the stock. In the case of a trailing stop loss, your stock will be sold at a price of $10.80. What happened next determines which is more advantageous. If the stock price subsequently falls from $10.50 to $9, the trailing stop loss will be the winner. However, if it rises to $15, a hard stop loss is a better choice.

Proponents of stop losses believe that they can protect you from rapidly changing markets. Opponents believe that both hard stop loss and trailing stop loss will make temporary losses permanent. It is for this reason that any type of docking requires careful planning.

5. Dividends

Investing in dividend-paying stocks may be the least known way to protect your portfolio. Historically, dividends accounted for a large part of the total return on stocks. In some cases, it can represent the entire amount.

Having stable companies that pay dividends is an effective way to provide above-average returns. In addition to investment income, research shows that companies that pay generous dividends tend to grow faster than companies that do not. Faster growth usually leads to higher stock prices, which in turn generates higher capital gains.

So how does this protect your investment portfolio? Basically, by increasing your overall return. When stock prices fall, the dividend buffer provided is important to risk-averse investors and usually leads to lower volatility.

In addition to providing a cushion in a sluggish market, dividends are also a good hedge against inflation. By investing in blue chip companies that both pay dividends and have pricing power, you can provide your portfolio with unmatched protection for fixed income investments (except for Treasury Inflation Protected Securities (TIPS)).

In addition, if you invest in “dividend aristocrats”, that is, companies that have increased their dividends for 25 consecutive years, you can almost be sure that these companies will increase their annual dividends while the bond dividends remain the same. If you are about to retire, the last thing you need is a period of high inflation to destroy your purchasing power.

6. Guaranteed notes

Investors who are concerned about capital preservation may consider considering capital-guaranteed notes with equity participation.They are similar to bonds in that they are fixed-income securities, and if held to maturity, return your principal investment to you. However, their difference lies in the equity participation that exists at the same time as the principal guarantee.

For example, suppose you want to buy a $1,000 principal-guaranteed note linked to the Standard & Poor’s 500 Index. These notes will expire in five years. The issuer will purchase a zero-coupon bond that matures at about the same time as the bill at a price lower than the face value. No interest is paid when bonds are redeemed at face value before maturity. In this example, a $1,000 zero coupon bond is purchased for $800, and the remaining $200 is invested in S&P 500 call options.

The bond will mature, and profits will be distributed at maturity based on the participation rate. If the index rises by 20% during this period and the participation rate is 90%, you will receive an original investment of $1,000 plus a profit of $180. You will lose $20 of profit in exchange for your principal guarantee. But suppose the index has fallen by 20% in five years. You will still receive an original investment of $1,000; in contrast, direct investment in the index will drop by $200.

Risk-averse investors will find capital-guaranteed notes attractive. However, before joining, it is important to determine the strength of the bank that guarantees the principal, the basic investment of the bill, and the costs associated with the purchase of the bill.

Bottom line

Each of these strategies can protect your investment portfolio from the inevitable fluctuations in the investment world. Not all of these are suitable for you or your risk tolerance. However, putting at least some of them in place may help protect your principal-and help you sleep better at night.

InvestingClue does not provide tax, investment or financial services and advice. The information provided does not take into account the investment objectives, risk tolerance or financial situation of any particular investor, and may not be suitable for all investors. Investment involves risks, including possible loss of principal. Investors should consider hiring qualified financial professionals to determine appropriate investment strategies.

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