If you are like most investors then you probably have a long position in the stock market. Your portfolio goes up and down with the market. Your investment returns are relative to stock market returns and probably adjusted for a risk measurement like volatility based on your age and risk tolerance. If this is the case your investments have probably experienced nice gains over the past few years. After all, we are technically in a 9-year bull market!
Today the markets are considered to be expensive and by most measurements, they are. For example, the S&P 500 has a cyclically adjusted price-earnings ratio of 30.05 as I write this. The long-term average is 16.77 and a year ago it was at 26.69. Only 3 times in market history has the S&P 500 been this expensive based on that measurement.
That doesn’t mean they won’t remain expensive for years to come. Many investors are looking for ways to minimize their losses if markets do “revert to the mean” and drop back to historical averages. There are several ways to do this like moving your investments to cash or selling short, but who wants to do that?
Luckily there are ways to protect your portfolio without having to sell your current investments. After-all, we want to keep our good investments for long periods of time and remove “timing” risk from our portfolios as much as possible. This is why I want to show you how buying “puts” on an index or an S&P exchange traded fund like SPY can reduce your portfolio losses when markets go down while allowing you to keep your favorite investments for the long run.
Investors can create portfolio insurance for a cost by purchasing options called puts. A put is the right to sell an investment at a certain price. Now, this isn’t meant to be a lesson in options so I won’t get into how a put works today, but remember, if the market goes down in value that means your put options will go up in value, hedging your total portfolio against losses.
The best way to show you how this may impact a portfolio is to show you an illustrative example from our risk management software on what will happen to your portfolio in different market conditions based on historical investment correlations.
We will compare two $500,000 portfolios. The "Base Portfolio" will have a common allocation of 60% in SPY (S&P 500) and 40% in AGG (Core US Aggregate Bonds), which represents a common 60/40 split of equity to fixed income.
The "Proposed Portfolio" will also have 60% in SPY, but we will use 2.7% of the AGG portion to buy several 1 year at-the-money put options totaling $13,906 dollars. The only change in the proposed portfolio is the $13,906 less in AGG which is used to buy the put options.
Ok, time to run a hypothetical scenario. Let’s say over the next year the S&P 500 experiences what is considered a typical recession and drops to 1790, or a PE of 21.
The first portfolio on the right is the Base Portfolio titled (Clever Investor Holdings). The portfolio below that is the Proposed Portfolio titled (Clever Investor Proposal).
The base portfolio is predicted to lose a healthy $88,812, almost all because of the equity exposure to the S&P. This of course is why only 60% of the overall portfolio is invested in the S&P 500! Now look at the proposed portfolio and how minimal the losses are. The only difference between the two? The puts offset most of the losses. Congratulations Clever Investor, you have insured your portfolio against a future recession!
So what gives? Why doesn’t everyone do this?
Well for one, not everyone knows how to execute these strategies properly. Options strategies require advanced levels of investment experience. Beyond that, the catch is this, there is a cost to the insurance which must be accounted for. In this case the cost is $13,906 over a 1 year period, or 2.7% of the portfolio.
If one year goes by and the stock market stays flat or even goes up, you will lose that $13,906. In this example that represents 2.7% of your portfolio so your returns will be 2.7% less than if you hadn’t purchased these puts a year earlier. For this reason, it wouldn’t be efficient to do this year-after-year. But, you know that every year isn’t the same and as we stated in the beginning, markets are expensive. The potential for large losses is real.
Do you know how much your portfolio will go down during the next recession? If things start to get uneasy in the markets, do you have a professional who can protect your portfolio without having to sell everything, causing tax issues and potentially mistiming the market and causing you to miss out on future gains?
Here is the good news! At Arbor Retirement, we give free portfolio evaluations! You can even take our insight back to your current adviser. Reach out to us if you want a free analysis on your portfolio. We will tell you how much risk is built into your portfolio, and how to protect it without missing out on future gains, for free!
You can even take the risk test today.
Illustration Disclosure - The projections generated regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. Assumptions on rates of return and standard deviation used in this analysis are based on historical return data for each security and asset class. Past performance is no guarantee of future results. Results may vary with each use and over time