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The Ultimate Stock Market Insurance Policy

InvestorEducation / Options & Warrants Jul 15, 2010 - 10:37 AM GMT

By: Investment_U


Best Financial Markets Analysis ArticleKarim Rahemtulla writes: It’s a question that trickles in consistently from Investment U readers:

“How do I weight my portfolio properly in terms of asset allocation that offers a mix of upside potential and downside protection?”

Right off the bat, I’d say much of it depends on your individual situation and how old you are.

  • For example, if you’re older, you’ll want to have more assets in bonds, cash and income-generating investments – i.e. safer assets designed to protect existing wealth and grow it consistently.
  • On the other hand, if you’re younger and have more time until you retire, you can afford to take a few more risks – i.e. in growth stocks and a few more speculative investments.

At this point, I should stress categorically that you should never risk more than you can afford to lose.

In short, there’s no one, easy answer. But I’ve recently been road-testing a new portfolio, designed to provide the ultimate stock market insurance policy. And here it is…

A Critical Investment… But One That Rarely Pays You Back

Nobody likes to lose money. But when you take out an insurance policy, that’s essentially what happens on many occasions. It’s the investment you hate to make because it never seems to pay you back.

However, sometimes it’s worth losing some money in order not to lose a lot of money. You gripe about how much it costs, but insurance allows you to sleep better at night, so you pay it anyway. It’s the best way to protect yourself against a catastrophe.

In Florida, for example, when you buy insurance on a $300,000 house, you pay around 1% of the replacement value. It’s a policy that will likely never pay off, but 1% is a small psychological price to pay – even on an asset that may not appreciate for a while.

So why should your stock portfolio be any different?

If you want insurance on your portfolio, you’ll have to pay there, too. If you don’t, you’ll leave yourself at the mercy of a volatile and unforgiving market. And why leave yourself open to disastrous losses when they can be avoided?

So to come back to our original question at the top: “How do I weight my portfolio properly in terms of asset allocation that offers a mix of upside potential and downside protection?”

I’ll show you…

Can You Really Have Upside Gains and Downside Protection? You Bet…

For several months, I’ve been toying with different options strategies, portfolio allocations and various market instruments to see what would work best in case of a market meltdown.

My goal is to enjoy both upside gains and downside protection. In short, outperform the market on the way up and lose less than the market on the way down.

This means I’ve incorporated conservative positions like cash, plus more speculative positions like stocks and options.

I threw the portfolio out there at the best (i.e. worst) time – during the market’s recent decline. It was a real case of “sink or swim?” And the thing is like Michael Phelps! The results were much better than I expected.

Your Five-Asset Portfolio Insurance Policy

From high to low this year, the market has dropped by 11%. But my experimental portfolio has only shed 3%. It’s got the following allocation…

  • Cash – 35%
  • Stocks – 30%
  • Deep-in-the-Money Covered Calls – 20%
  • LEAP Options (long) – 10%
  • Short Positions (both LEAPS and other options) – 5%

So what companies are in the portfolio?

~ Stocks: On the stock side, about 60% of the positions are made up of low-beta names like Wal-Mart (NYSE: WMT) and healthcare firm Bristol-Myers Squibb (NYSE: BMY).

The remaining 40% is comprised of higher-beta companies such as resource stocks and small caps.

~ Shorts: Most of the short positions were executed using both long and short-dated puts on the S&P 500, with varying strike prices.

Some of the S&P strike prices were close to at-the-money (near the current levels of the index), while others were quite a bit out-of-the-money.

The latter offers protection in the case of an unpredictable, stomach-churning short-term collapse – i.e. “black swan” trades. And while they might lose money, since catastrophic collapses aren’t frequent occurrences, it’s an insurance policy that allows me to sleep better at night.

The main reason for the portfolio’s market outperformance was the short positions and covered call trades. Both acted as counter-trend investments, which increased in value as the market went lower.

The Watchword: Volatility

So what happens if the market dips even lower or heads higher?

Well, I’m still in the observation phase of this model portfolio’s effectiveness, so I’ll keep you posted.

What I can say, however, is that volatility could be our friend here. Yes, that’s right. While many investors run scared as volatility kicks higher, it could act like rocket fuel, since it will boost the value of the short options trades more substantially. Stay tuned for more updates on how this portfolio works out.

Good investing,

Article -

Karim Rahemtulla

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