Those screams you hear are not over the new Avengers movie. They are both average and institutional investors, reacting to the resurgent volatility in the stock market.
There have been more days in the past three months in which the S&P 500 has moved more than 1% than at any other time in recent history. If all of this volatility is getting to you, the average investor, don’t feel badly. It’s a perfectly normal human reaction.
So what can you do to hedge against all this market volatility?
Emotion causes volatility. Market volatility is how we measure risk. Despite the fact that the stock market has been in existence for well over 100 years, and markets in general have existed since the beginning of time, emotion is and always will be a primary factor in how stocks and other securities move.
Money managers and advisers will crow all day about their returns. Yet those spectacular numbers they hand you are presented in a vacuum because they don’t tell you how much risk they take to achieve those numbers. I can almost guarantee you that your money manager or adviser, or even a portfolio that you built yourself, carries way too much risk.
How to Diversify Your Portfolio During Market Volatility
The single biggest defense you have against market volatility, or risk, is a properly diversified investment portfolio. That means having a significant allocation of your portfolio invested in non-correlated investments. These are investments that do not correlate, or follow, the rest of the market.
You want a portfolio that has investments that move both up and down regardless of which way the stock market and bond markets are moving.
The Liberty Portfolio, my investment advisory newsletter, does exactly this. Here, on the Liberty Portfolio’s first anniversary, I can tell you that it delivered returns that vastly outstripped the real rate of inflation, while delivering less risk than the market.
That’s because it is stacked with non-correlated investments and other trading and option strategies designed to smooth out overall risk.
There are other ways to hedge against market volatility, if you feel that your portfolio is working well enough in regards to your own risk profile.
Another approach you can take to soften market volatility is to mirror a strategy that some hedge funds take. These hedge funds may be long a group of stocks, while shorting the overall market. If you are very confident in the stocks you own but are very bearish on certain sectors or even the overall market, there are ETFs you can take advantage of.
Perhaps you think that global stocks are going to struggle in the near future. In that case, you could buy the ProShares Short MSCI EAFE (ETF) (NYSEARCA:EFZ).
There is no reason to confine yourself to equities. The Federal Reserve is likely to keep raising interest rates, which means bond prices will go down. In that case, you can buy the Direxion Shs ET/Daily Totol BD MKT (NYSEARCA:SAGG), which effectively shorts the entire bond market.
The INDEXIQ ETF Tr/IQ Hedge Multi-Stra (NYSEARCA:QAI) takes a very specific non-correlated approach that tries to offer “the risk-adjusted return characteristics of the collective hedge funds using various hedge fund investment styles, including long/short equity, global macro, market neutral, event-driven, fixed income arbitrage and emerging markets.”
The fund is composed of other ETFs and presently owns 22% in Treasury bonds, 7% in investment-grade bonds, 6% in treasury bills and a swarm of other assets.
Another approach you might want to consider, but only if you have stocks that you think are topping out, is to use an option strategy known as selling covered calls.
Selling these covered call several months out will generate a significant amount of upfront income, which also has the effect of hedging your long position. Just be aware that your long position could be forcibly sold if the stock price keeps rising.
Lawrence Meyers is the CEO of PDL Capital, a specialty lender focusing on consumer finance, and is the Manager of The Liberty Portfolio at www.thelibertyportfolio.com. He does not own any stock mentioned. He has 23 years’ experience in the stock market and has written more than 2,000 articles on investing. Lawrence Meyers can be reached at TheLibertyPortfolio@gmail.com.