The S&P 500 marked its strongest first half since 2013 thanks to solid corporate earnings and expectations for improved economic growth.
The Dow Jones Industrial Average rose almost 8 percent in the first six months of the year, also its best showing since 2013.
The S&P is up a little more than 8 percent this year. Even the Eurozone sentiment has jumped to its highest level since before the financial crisis.
Until recently, the stock market’s volatility has been at a two-decade low and has been as boring as boring can be. Buying on the dips that have occurred here and there has been a successful strategy.
That said, there are signs that things might be changing. Recently, the VIX fear gauge sounded a warning. It had its fourth-biggest jump before falling back to one of its lowest readings. The Fed is going to begin tapering its large portfolio in the near future.
It’s impossible to predict when a correction will occur. But, as often is the case, the longer time between corrections, the larger the correction that does occur might be.
What can an investor do to protect their gains when that correction does occur?
Here are a couple of standard Wall Street hedging ideas:
Buy protective “puts.” For a price, an investor can purchase a contract that gives him the right to “put” a stock to another investor at a certain price within a certain time period. An investor can sell a “call” option against stocks in one’s portfolio. This will bring money in versus spending money on a “put.” The “call” option will give some protection to the downside.
Stop orders are instructions that trigger the sale of an investment if its price falls by a specific level.
Managed futures are another way to hedge against market loses. They invest in contracts of things such as currencies and stocks that might have an opposite correlation to the general stock market.
For most of the readers of this column, though, the strategies just mentioned hold some challenges.
One is cost. Buying “puts” and managed futures involve cost to the investor. Managed futures have lost money for almost seven years now. How long will the average investor hold a losing investment? Yes, managed futures may perform in a positive manner during a correction, but is it worth the many years of negative performance?
Stop orders will get you out of the stock market once triggered. But then what?
If you are retired and depend on your investment portfolio for income and turn all or most of your portfolio into cash, where does your income come from? Until you reinvest your proceeds, your income needs will come from your principal. Not a good idea in most cases.
Second, once you are out of the market, when do you get back in? That’s the tough question. I can speak of many investors and advisers who were out of the market for several years after the financial crisis. They missed a lot of up days that followed.
One simple suggestion that I believe makes more sense: Stay invested. Trying to time the market as to when to get in and out is typically a fool’s move. Your asset allocation is the main driver to your performance. Asset allocation refers to what percentages you have in the three main asset groups of stocks, bonds and cash.
It’s time to revisit that as many investors are more over-weighted in stocks because of such low interest rates than they should be. In my opinion, it’s time to begin moving those portfolios back to the more normal allocation. That’s particularly true for the retired investor.
Bonds may also be considered a hedge against a correcting market as they tend to rise in value during one. As I wrote in a recent column, interest rates are moving up slowly and a good fund – and a good adviser – should be able to handle that situation.
In the stock section, maybe it’s time to again look at investments such as utility stocks and other defensive types of stocks. Those tend to hold up better in a correcting market than, say, technology stocks.
Above all, build a strong portfolio that will weather a correction. That means a low-cost diversified portfolio that will go up in a good stock market. It will also fall during a correction.
But, it will also go up when the market reverses its correction. Dividends and interest will continue to be paid to the investor during the correction phase.
The stock market has always rebounded. Staying put with one’s portfolio when it does correct is the most-sensible strategy for almost all investors.
The day the stock market doesn’t rebound will be another story.
Until then, stay invested through thick and thin.
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