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Independently Financed

Independently Financed

Thinking about portfolio protection

January 20, 2018 by indyfinance 12 Comments

Downside risk protection is one of the more interesting things to think about in investing. After all, if you ask me, “should I own US stocks or international stocks?” my answer will be “yes.” We can quibble or even fight about what proportion of your equities should be large cap, small cap, growth, value, etc., but those are all ultimately battles around the margin. The fact is, owning equities is the best way to participate in the profits of publicly traded companies, so if you want to participate, you should own them.

So, if investing in global capitalism has a positive expected return, why would you worry about downside risk at all? The answer isn’t war on the Korean peninsula, or Chinese industrial espionage, or the first of what I can only assume will be many US government shutdowns in the coming years. The reason is (almost) entirely behavioral: if you, personally, are going to make decisions you know to be bad when your portfolio tanks, then one way to avoid making those bad decisions is to put in place protections that will keep your portfolio from tanking.

Faithful readers know about my unfortunate literal tendency, and it’s remarkably difficult to find any concrete descriptions of how a person might implement a strategy to protection their portfolio from downside risk. So, I thought I’d take a swing at it.

Options

It’s easy to find people online who are happy to sell you options trading strategies with a positive expected return. I do not believe those people and don’t think you should either. But options really do exist, and you really can use them to provide portfolio protection — as long as you’re willing to pay for it.

To see how this would work, let’s use the example of SPY, the S&P 500 SPDR and the most heavily-traded ETF in the world every single day. SPY is currently at $280.41 and, in 2017, paid $4.79 in dividends, which we can use as a baseline (under most — but not all! — market conditions dividends are stable or rising). Assume a portfolio of 100 shares of SPY, which paid $479 in 2017 dividends.

According to Nasdaq’s information at the time of writing, you could buy 100 option contracts giving you the right to sell SPY for $280 per share at any time before April 20, 2018, for $543. That would give you downside protection should the price of SPY fall by more than $0.41. Of course, it would also mean giving up $543 of your $479 in 2017 dividends. If the price of 3-month options remained constant quarter-to-quarter (more on that in a moment), you’d end up paying $2,172 in annual options premia, turning a modestly positive 1.71% yield into a negative 6.04% yield.

If you were able to do that, would it be worth doing? Well, that depends. How bad a decision do you think you’ll make if the markets tank? If your portfolio loses half its value, will you sell everything and never touch stocks again? In that case, giving up 7.75% in annual returns might be cheap.

Of course, this exercise has insisted on complete downside protection using at-the-money puts covering an entire portfolio. Naturally, there are other strategies you could use to provide partial downside protection.

Since options are cheaper the further out of the money the strike price falls, you could buy out-of-the-money put options, for example corresponding to your portfolio’s dividend payout. In the case of SPY, $118 (roughly a quarter of the $479 2017 dividend) would buy you 100 put options with a $252 strike price, roughly 10% lower than SPY’s last closing price. You would sacrifice a 1.71% dividend yield for protection from any fall in the price of SPY of more than 10%, while fully participating in any price rise. This is, incidentally, essentially how variable indexed annuities work, although they cap upside participation as well as downside risk.

One problem with such a strategy is that options prices are not constant quarter-to-quarter, so the same amount of protection could cost more when your contracts expire and you need to replace them. One solution would be to buy longer-dated puts.

Rather than paying $543 for an April at-the-money put contract, then in April replacing it with a July at-the-money contract, then replacing that in July with an October contract, and finally replacing that with a January contract, you could buy a January at-the-money put today for $1,402. It may take a moment to realize why the January contract doesn’t cost four times (or more) the April contract: the strike price of the January put doesn’t reset each quarter, and since SPY has a positive expected return, the option is priced on the (reasonable) assumption that it will be very far out of the money by the time it expires. In other words, if you want to reset your option’s strike price each quarter, you have to pay up.

Incidentally, for the $2,172 you’d pay for four equally-priced quarterly put options you could buy a January, 2019, SPY put with a strike price of $295, locking in a 5% price increase (but you shouldn’t).

Put strategy funds

Instead of getting involved in options trading yourself, you could pay somebody to do it for you. For example, Cambria Funds offers what they call a “tail risk” ETF, ticker symbol TAIL [full disclosure: I own two (yes, two) shares of TAIL in my Robinhood account]. Their strategy is slightly different from the ones I described above, since the fund uses bonds instead of equities to generate income that they then use to buy out-of-the-money puts. You can see their actual holdings here, they only have 13 positions so it’s pretty easy to understand the strategy, although for reasons I don’t entirely understand the ETF also pays a small dividend.

One thing to keep in mind is that since TAIL holds 95.5% of its value in Treasuries, you would want to use it to replace bonds in your portfolio, since it’s basically an intermediate-term Treasury fund with a small allocation to put options.

Sell part

The single easiest thing you can do to protect yourself from a fall in asset prices is to simply sell now, before the fall. If your equities have doubled or tripled since the depths of the financial crisis, there’s no rule that says you have to hold onto them forever. If holding some cash, or short-term treasuries, or inflation-protected securities, is going to make you more psychologically resilient against the inevitable crash, just hold some cash!

In tax-sheltered accounts that may be as easy as pushing a button, although for assets in taxable accounts be sure to consult with a fiduciary financial advisor or tax professional to understand the tax implications of selling appreciated assets. If you are still making contributions to IRA’s or workplace retirement accounts, you can also adjust how your ongoing contributions are allocated in order to build up a defensive position.

The problem of asset location

That last point raises an issue that I’ve only begun to struggle with, the problem of asset location, which arises because different investment vehicles have different rules about contribution limits and contribution timing.

For example, since funds in IRA’s compound tax-free, you’d ideally like them to be fully invested in assets with the highest expected returns. But since there are annual contribution limits, you’d also like to keep some of the value of the account in safe assets, or assets that are uncorrelated with the account’s most volatile investments. Once solution, counter-intuitively, could be to hold each year’s contribution in a high-yield taxable account (I like Consumers Credit Union’s Free Rewards Checking) and delay contributions until as late in the year as possible, in order to determine whether each additional contribution should be added to the high-risk or low-risk portion of a portfolio. Contribution limits are so low to such accounts that delays are unlikely to have much effect one way or the other in the accounts of high-net-worth individuals, however.

Likewise, workplace retirement plans that are funded through paycheck withholding require you to specify how your biweekly or monthly contribution is to be allocated. Whether or not you can accelerate contributions in response to events in the market depends on your payroll department and the time of year, and in any case you’re subject to annual caps on elective employee contributions, meaning for some people there may be strategic value in holding less-volatile assets even within an account that internally compounds tax-free.

Filed Under: investing

Reader Interactions

Comments

  1. mom says

    January 20, 2018 at 8:01 pm

    I think a more important question is how worried should you be that the current market is a “bubble?” obviously, the recent run-up may be fantasy, and there will be a “correction,” but how much. I am very pessimistic about the US economy, but the more I look at the world economy the more I become a believer. emerging markets are where the growth is, much of africa is booming, Asian…… I would think protecting the risk would be better done by careful asset allocation and diversification. . The Calvert emerging mkt fund is up something crazy like 44%. ‘course you have to have a lot to buy into it.

    Reply
  2. sh says

    January 25, 2018 at 11:02 am

    If history is any indicator, buying foreign stocks is not the best way to protect against a downfall in US stock market. Almost all stocks from major foreign markets start going down as soon as US market crashes, they recovery may be different (sooner?), yet perhaps there are better protections out there. What do you think about buying an index that tracks gold price?

    Reply
    • indyfinance says

      January 26, 2018 at 12:56 pm

      sh,

      I don’t think you should think about gold ETF’s as protection from the stock market. If the stock market drops 50% your gold ETF may retain its value, but so does cash, so I don’t see the value of holding a volatile commodity instead of cash in a high-interest account.

      Gold is usually treated as a hedge against out-of-control inflation, not falling stock prices. I do not expect inflation to be a serious problem for the foreseeable future, but if you do, it’s perfectly reasonable to have a small (5%?) allocation to gold. But if you’re worried about inflation, there are more practical ways to hedge against inflation: move within walking or biking distance of work to protect yourself against rising gas prices; start a garden or farm to protect yourself against rising food prices; buy high-quality clothing and learn to fix it yourself instead of replacing it with new (that goes for the bike, too); own your own home instead of renting to protect yourself from rent increases.

      —Indy

      Reply
      • sh says

        January 26, 2018 at 3:06 pm

        I expect a major inflation, along with (or preceding) a stock market crash . One thing I definitely don’t want to hold on is cash,

        Buying long term put options is a possibility, but if I buy the option from, say Schwab, and Schwab goes bankrupt during the crash, who gets the assignment when I want to exercise the option?

        Reply
        • indyfinance says

          January 27, 2018 at 2:02 pm

          sh,

          I wouldn’t worry too much about the put assignment, it’s handled through a central clearinghouse so it doesn’t matter who your broker is.

          It might help to ask a slightly different question: what is the purpose of your public market investments? The purpose of my public market investments is tax advantages (reducing taxable income by contributing to a solo 401k, which can only be invested in public markets) and passivity. I have other “active” money that I allocate to, for example, high-interest checking accounts, miles and points arbitrage, etc. I just bought some bitcoin. If the thing you want from your public market investments is for them to go up all the time, then you’re looking in the wrong place, because public markets are going to do all sorts of things, up, down, sideways, etc.

          Public equity markets will give you, over the very long term, the return of public companies. Nothing more, nothing less. Should the return of public companies be a part of your portfolio? Well, what are your other options? That’s why I suggested buying a farm, learning to fix bikes, etc. It seems to me that people ask the public market part of their portfolio to do more than it’s qualified or designed to do.

          —Indy

          Reply
          • sh says

            January 28, 2018 at 2:37 am

            Under normal conditions I have been a passive investor who owns a few ETFs and stocks, usually for long term. I occasionally may modify my portfolio to focus on those parts of market that are likely to be more promising during the next year or next few years. So I understand that public equity markets will give me, over the very long term, the return of public companies, and I am fine with that, though I do small things to hopefully do a bit better.
            But I don’t feel like near future in this country should be considered “normal conditions”. I expect a stock market crash, inflation (because of a significant decrease in USD exchange rate and also because of additional stupid barriers to free international trade that are being implemented in US). My goal for next year or two, is to protect my wealth against inflation and stock market crash. I don’t think real estate will be a stable market. That’s why I am thinking about buying put options, and/or DGP or USLV.

          • indyfinance says

            January 29, 2018 at 12:29 pm

            sh,

            In that case I think it makes perfectly good sense to invest, say, 5% of your portfolio in a put strategy and 5% in gold. If inflation takes off then the gold should benefit, and if the stock market tanks then the put strategy will pay off. If the stock market continues to rise and inflation stays muted, you’ll still be participating with 90% of your portfolio. That’s perfectly reasonable IF you understand in advance that your strategy has a negative expected return. If you’re ok “paying” for portfolio protection with puts that are likely to expire worthless, and with gold that’s likely to underperform the stock market, then go ahead and do it. But if you’re adding a put strategy and gold to your portfolio with the expectation they’re going to outperform the market, you’re setting yourself up for disappointment, and I would be worried about how you’re going to react to that disappointment. Are you going to stay disciplined? Are you going to double down on your failed insurance strategy?

            In other words, lots of things are hypothetically worth doing if they’re done in a disciplined way, but almost nothing is worth doing in an undisciplined way.

            —Indy

  3. sh says

    January 25, 2018 at 11:03 am

    Follow

    Reply

Trackbacks

  1. You got your tax cut. Now what? - Independently Financed says:
    January 31, 2018 at 7:40 pm

    […] had an interesting exchange in the comments of this post with reader sh on the subject of portfolio protection. I won’t relitigate the question here […]

    Reply
  2. Page not found - Independently Financed says:
    February 12, 2018 at 11:06 pm

    […] Thinking about portfolio protection […]

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  3. If you care about deficits, this is what you should care about - Independently Financed says:
    February 13, 2018 at 1:01 pm

    […] you worried about a stock market crash? You can pay for a put strategy that protects you from big downside […]

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  4. The Danger Is Still Present In Your Time - Independently Financed says:
    March 12, 2020 at 10:24 pm

    […] advantage of the present market excitement to very gradually shift out of my rapidly appreciating put strategy ETF into newly-cheap stock market mutual funds, and if the market falls further I’ll buy even […]

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