Darren Winters: Protecting Your Investment Portfolio

It might be timely to start thinking about protecting your investment portfolio, particularly with storm clouds gathering.

Nobody knows for certain where this market is heading. While the fundamentals aren't that good, it’s still not enough for us to know with absolute certainty where this market is going next.

Central banks do indeed influence market trends, both directly and indirectly, but knowing when and the extent of their future actions is, in reality, educated guess work.

However, what we can be absolutely sure of is that markets are and always will be volatile. Over the past century, 5 percent falls typically happened three times a year. Corrections of 10 to 15 percent are less frequent, usually occurring once in a year, or in a two year period and 20 percent bear falls usually occur once every five years.

Ironically, volatility for a trader can be his best friend, but it can also be his worst enemy. If you understand how to make volatility your best friend then you will not fear volatile markets, but rather see them as an opportunity.

Just like the skilful sailor can harness the energy of the wind, irrespective of what direction it is blowing by orientating the direction of his sails, thereby trapping the wind and creating motion, so too can the trader use volatility in their trades to create profits. You may need to deploy different trading strategies to benefit from volatile markets, but just because the market flip flops from one direction to another doesn't mean that you can not profit from the volatility.

The wind maybe blowing foul but you can still trap the energy by moving your sails.

There's no ideal position to orientate your sails. If you want to keep moving you'll need to position your sails according to the current wind direction. Likewise, in trading a strategy that worked once may not be profitable in the future. In other words, trading strategies need to be flexible (flexible thinking)

Have you ever wandered why a twig can survive a gale-force storm and a supertanker sometimes ends up smashed to pieces? One structure is fixed and the other is flexible.

Fight an irresistible force and you are doomed, but go with it and you may prosper.

Let's look at some ways you can hedge your investments in a volatile market.

The buy and hold strategy, might not be suitable for everyone, whether it is will depend on your investment time frame. If you are approaching retirement in say a few years, you haven't got the luxury of waiting five years for the market to pick-up again, assuming you have been caught out by a 20 percent bear drop against your portfolio of investments.

So what other options are available?

The most obvious one is to remain liquid. Sell some equities and remain on the sideline in cash. In this case you are not really hedging, you are just not participating. Cash is king in a crisis, but in the long term cash is never a good investment strategy. Nobody got rich just holding cash.

Cyclical Investing. This investment strategy involves moving into defensive stocks, such as consumer staples, utilities, insurance, precious metals, healthcare and bonds. In this case, the investor is rotating their portfolio away from cyclical stocks, tech stocks, non staples and diversifying their investments towards sectors that weather better in economic hard times. But again this is not a pure hedge investment strategy.

The investment strategy behind a pure hedge is to protect your investments or even profit from a stock market decline.

Options protective puts. This can be an attractive investment strategy for investors because of their leverage nature. For example you could buy a protective put, if you reckon that the shares in your portfolio are about to decline. If the stock market moves against your portfolio, then you profit from a decline while still retaining your stock and when the bounce back comes, which it usually does if it is a blue chip stock you profit again from the rise. A Tesco (British Supermarket) put option would have been a profitable play. Admittedly, market conditions are tough but could the company (Tesco) recover if it were well managed again. Imagine if Tesco's stock were to flat line for several months and you decide to close your put position. If you hold Tesco stock in your portfolio you have profited from the stock fall and have lost no money. Moreover, with the stock still in your portfolio you are ready placed for a future upturn in the stock, if any.

There are many more complicated hedging methods. Multiple put/call option packages such as bear put spreads and other derivatives such as futures and CFDs are also popular for hedging. These, however, carry significantly more risks and should only be employed by those familiar with them.

Another way of looking at hedging for the conservative investor, with a few years to go before reaching the retirement age, is to see it like an insurance policy. You purchase an insurance policy to insure your house against fire, theft, water damage etc. You hope not to get burgled or your house damaged by fire, but for peace of mind you pay an insurance company a premium to take the problem off your shoulders.

In a similar way, that is why large investment portfolios, particularly when the investor has a short time frame, tends to opt for having their investments fully hedged. It's an insurance policy, which is designed to protect your wealth in a stock market crash.