Position and protect
One of the accepted givens in the stock market is that every so often we will have, at best, a bear market (defined as 20% down from the highs) or at worst a market crash (loosely defined as a sudden 20% decline down in a short time). These definitions are far from exact, but basically I am talking about when the value of your portfolio declines a significant amount over a relatively short or medium-term period (days to maybe a year or more). The point is that markets never go up forever; there will always be periods when the trend is down.
Many of us spend a large part of our time worrying about when this downtrend will occur and plan on selling before such an event takes place in order to get back in at the bottom. In a perfect world that would be ideal: selling at the top and buying at the bottom would markedly improve our wealth. But as I have written before in this column, that is a total pipe dream, we’ll never exit at the top and we will just as certainly miss the bottom, leaving us actually poorer for the attempt.
So how do we position our portfolio for the inevitable market decline? As we have written before, the best way to survive a market decline is to own seriously top-quality shares – the best stocks in the best sectors. Sure, these stocks will also see their share prices falling with the overall market and there is no certainty that the stocks will fall less. In fact, if they are real quality they may have run up further than the average and hence could well fall by a larger percentage on the way down. But the bigger picture is that if you own the best, these stocks will survive and recover quickly and make new highs long before the second rank- ers have recouped their losses.
I always harp on about this, but the best stocks in the best sectors continue to dominate and therefore give the best return but also recover quicker. Far too often we buy stocks in the hope that these will rocket higher and make us wealthy in a hurry – but that seldom, if ever, works. Pick the best sector and then find the winner in that particular sector.
Aside from buying the winners, how do we protect a portfolio? In truth, that is all I do: I have a small list of quality stocks and I hold them forever, with one exception. If they lose their way and no longer dominate their sector I will exit them and purchase the new winner in that sector.
There are however other options to protect you in a market downturn, such as hedging. The idea behind hedging is to buy derivatives that will increase in value as the market declines. These could be options/ warrants or short positions in contract for differences (CFDs), singlestock futures (SSFs) or even a short position in the Alsi futures.
All of these hedging alternatives carry costs, not only transaction and funding costs but also the cost of them falling in value, as the market is moving higher. So while your overall portfolio is rising, this hedge is taking some of the shine off your overall profits. The other problem is that a perfect hedge is almost impossible.
So, the bottom line is that I do not hedge against a market downturn even though I know for certain one is coming (but I never know when it is coming). Rather, I manage the risk by buying quality that enables me to sleep at night during the good and bad times.