4 Ways to Protect Your Portfolio (BLOG)

"Double your money in less than two years." That's the sort of suspicious offer made in spam emails or by boiler-room pump-and-dump schemers. Incredibly, though, the Standard & Poor's 500 Index ($INX) of large U.S. companies generated exactly that type of return from its March 2009 low through the middle of February.

The index hadn't doubled that quickly since, well, ever.

But the recent stock market decline has investors again looking for a way to insure against losses without forfeiting future gains.

There's no such thing as stock insurance, strictly speaking. Prudential won't write you a policy against your stocks losing 20% because, for one thing, covering colossal financial losses that tend to fall to all policyholders simultaneously isn't a good business model for an insurer (see: AIG, mortgage defaults). However, investors can build their own portfolio protection in a variety of ways.

Not all are good deals, though.

Puts
Puts are a type of option contract that gives the buyer the right to stick an investment to the contract seller at a specified price, up to a specified expiration date.

For example, shares of International Business Machines (IBM, news) recently traded at around $168. The right to sell 100 shares of it at $165 by the end of this week is obviously not terribly valuable, so such a contract recently went for just $41, plus a typical online broker's commission of $15 or $20. To reserve the right to sell at the same price anytime through January 2012, however, is worth more -- 25 times as much.

Put holders can sell their contracts anytime before expiration. Prices rise as the underlying stock moves closer to being "in the money," or below the strike price, but prices erode as the expiration date nears.

Volatile stocks, the ones most demanding of downside protection, have the priciest puts.

Buying puts for every stock in a portfolio is tedious and generates broker commissions for each trade. Buying a single put to cover a broad basket of stocks, like the SPDR S&P 500 (SPY, news) exchange-traded fund, is easier and generates fewer commissions. But the movement of the S&P index might not match the movement of individual stocks or mutual funds.

Such a strategy is also costly. The SPDR traded at about $132 earlier this month. A put option giving an investor the right to sell 100 shares at $120 per share at any time before April 1, 2012, could have been purchased for $621. That's nearly 5% of the value of the SPDR position, and the protection would run for less than a year.

If the stock market has historically returned 7% a year, after inflation, paying a 5% protection fee isn't a good long-term strategy.

Renowned value investor Warren Buffett participated in a giant index put transaction during the recent financial crisis, but he was selling protection, not buying it -- as good an indication as any that such protection is overpriced.

Zero-coupon wrap
Most bonds provide interest payments called coupons. Bu that's not the case with zero-coupon bonds like the popular EE Savings Bonds from the U.S. Treasury. Instead, these bonds are bought at a discount to their maturity value.

Zero-coupon bonds are more volatile in day-to-day trading than coupon-bearing bonds, which isn't an issue for an investor who holds to maturity. In exchange for that volatility, "zeroes" typically offer slightly higher returns.

They can be ideal for someone who has a known obligation -- say, using $100,000 in savings today to pay for college costs 12 years from now.

Zero-coupon Treasury STRIPS (separate trading of registered interest and principal securities) maturing in February 2023 recently sold for $64.89, meaning it would cost $64,890 to secure a maturity value of value of $100,000 at that date. The implied yield is 3.7%, or about 20% higher than the yield on traditional 10-year Treasury notes. The remaining $35,110 of today's savings can be invested in stocks or mutual funds, with the comfort of knowing the total account principal won't be less than $100,000 in 12 years.

What are the drawbacks? Even though zero-coupon bonds don't pay current interest, investors must pay taxes on the phantom interest produced by their gradual accretion toward market value.

Also, $100,000 in 12 years won't have the same buying power as $100,000 today because of inflation; the stock portion of the investment may help with that. Interest rates are relatively low at the moment, which means a zero-wrap strategy might leave investors with too much money in low-return bonds and too little exposure to stocks.

Finally, be careful about fees. Zero-coupon bonds are a notorious hiding place for gigantic broker markups. Securities regulators have found instances where markups exceeded 6% of the purchase price. If your broker is your nephew, pay 0.5%. If not, pay less. Markups should be stated clearly on trade confirmations.

Stock index annuities
An annuity is a contract in which an insurance provider makes periodic payments to the holder. The payments can start right away (immediate annuity) or in the future (deferred annuity). Some annuities have guaranteed rates of return (fixed annuities) and others offer a chance of higher returns along with a chance of loss (variable annuities).

Somewhere between these are stock (or equity) index annuities, which offer a minimum base return and the possibility of a higher return if a benchmark like the S&P 500 index has a good year. Sound too good to be true? It is.

The Financial Industry Regulatory Authority calls index annuities "anything but easy to understand." Typical ones offer low guaranteed returns of 1% to 3% that apply to only a portion of the portfolio -- say, 87.5% of it. If the index climbs 15% in a given year, many index annuities limit investor gains to a portion of that (say, four-fifths of the increase), or deduct a generous asset fee (3% or 4%) or simply cap gains at 8% or 10%.

Given the frantic nature of stock returns -- the S&P 500 has returned more than 20% in eight of the past 20 calendar years -- capping gains defeats the purpose of being in the market. And although annuities can offer some of the same tax benefits of retirement accounts, they have some of the same restrictions, including penalties for investors who withdraw money early.

The old-fashioned way
The best flood insurance is to build on high ground. Instead of looking for products that can offset stock risk, most investors would be better served by building safer portfolios.

If you're worried about a downturn, that means shifting more money to fixed-return investments (bonds). Among stocks, it means selecting ones with modest prices relative to earnings.

Reduce exposure to an economic downturn by favoring companies whose products and services stay in demand when shoppers turn frugal (think soap, not snowmobiles). Avoid companies with significant debt, because debt amplifies returns, good and bad.

And favor companies that provide decent current income in the form of dividends. A 4% yield, reinvested, doubles an investor's money in 18 years if the price stays the same, sooner if the price falls and rebounds, and much sooner if the price continues to rise.

Yields of that size aren't common today, but more than 40 S&P 500 members have them.
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