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How To Hedge a Portfolio Against a Stock Market Downturn

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Why Hedge a Portfolio Against a Stock Market Downturn

Stock Market Sell Off

With the stock market sitting at levels not seen in years, it is time to consider how to hedge a portfolio against a stock market downturn to protect investment capital.  An important part of long-term investing is hedging against a stock market downturn to hold onto gains, especially during times when the stock market has experienced a prolonged bull market run and stock valuations are lofty.  Hedging against a downturn is done to protect the value of an investment portfolio and also to ensure that money is available to buy into the market at lower levels after a sell-off.  Hedging is also done to ensure proper investment portfolio diversification, so that exposure to stock investments is not excessive.

The Time Has Come To Hedge a Portfolio Against a Stock Market Downturn

Bear Market Trading Ideas
Since the Great Recession of 2008 / 2009, the stock market has been the best game in town for investors looking to grow the value of their investment portfolio.  Other asset classes, from bonds to real estate, have been mired in problems related to the steep recession, and provide uncertain future returns as the Federal Reserve normalizes interest rates in coming years.

While stock market indexes and investment portfolios invested in stocks have made incredible gains since March 2009, and may experience continued gains as the United States economy grows, the risk of a downturn in the stock market is growing, as stock valuations become pricey.  With the stock market in the fifth year of a bull market run and with average price to earnings ratio (P/E ratio) for S&P 500 stocks about 10% above their long-term average of approximately 15, hedging a portfolio against a stock market downturn is a prudent strategy.

How To Hedge a Portfolio Against a Stock Market Downturn

Hedge a Stock Portfolio
There are several ways to hedge against a stock market downturn.  No one way is the correct way.  What works during one economic time, may not work during another.  Hedging can be done on either a short or medium-term basis, and can include several hedging strategies to diversify a hedge against losses in stocks.

The following are some hedging ideas to hedge a stock investment portfolio against a stock market downturn.

Short-Oriented ETFs and Mutual Funds – One of the most direct ways to hedge a stock investment portfolio against a downturn is to buy a short-oriented exchange traded fund (ETF) or mutual fund.  Short-oriented funds go up when stock market go down.  They are also known as inverse funds or bear funds.  They can be straight one to one ratio funds, or can be leveraged to move in a two to one or three to one ratio opposite the movement of stock market indexes.

Defensive Stocks – One of the most popular ways that investors ride out a stock market downturn is by buying defensive stocks that have the tendency to outperform the broader stock market as the stock market indexes lose value.  Defensive stocks include companies that provide products and services that are essential to consumers, such as consumer staples, healthcare, and utilities.  Some of them have the added benefit of paying dividends.  Defensive stocks can also be purchased via ETFs that focus on defensive stock sectors.

Cash – “Cash is king” is a well known statement made by Wall Street bears when they think the stock market is overvalued and heading for a correction.  While cash currently earns very little interest in cash accounts, it does at least hold its value (minus inflation) and is a way to hedge a portfolio against a stock market downturn.  Holding cash is a poor long-term investment in the current low interest rate environment.  But, if money is shifted from stocks to cash and rides out a stock market sell-off, it can be redeployed into stocks at lower prices once the sell-off has run its course.

Treasury Bonds – Shifting money from stocks to bonds is one of the most common ways that investors hedge against a stock market downturn.  It is known as “flight to quality”, as investors shift funds from stocks to Treasury Bonds.  The problem with using this hedging strategy to hedge against the current stock market bull-run is that Treasury Bonds are also at multi-decade highs, and may lose value, if interest rates rise.

Highly Rated Corporate and Municipal Bonds – Moving money from stocks to highly rated corporate or municipal bonds is another way to hedge an investment portfolio, while at the same time diversifying a portfolio into other asset classes.  As is the case with Treasury bonds, many corporate bonds are also at multi-decade highs, and could lose value if interest rates rise, and therefore they are not very useful as a hedging instrument in the current economic environment.  Municipal bonds are depressed in value due to recent municipal bond defaults, such as the City of Detroit, and the risk of future municipal defaults.  If the economy falters, municipal bonds may lose more of their value, as issuing governmental authorities have trouble making their debt payments and more of them go into default on their bond obligations.

Volatility ETFsVolatility ETFs generally increase in value as the stock market declines in value.  Volatility ETFs are short-term stock market hedging instruments that can be used to hedge against a stock market sell-off.  They are only useful when a stock market sell-off appears imminent, as holding volatility ETFs over long periods of time is a losing proposition, since the naturally lose value over time due to price decay associated with the stock options that they hold and derive their value from.

Index Put Options – Stock market investors with options trading accounts can hedge against a stock market downturn by buying put options on stock market indexes.  If a stock market sell-off occurs, put options written against stock market indexes increase in value.  It is best to stick to buying put options on stock market indexes rather than individual stocks to avoid the risk that individual stocks buck the stock market downtrend.

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