5 Ways To Protect Your Portfolio From Volatility

5 Ways To Protect Your Portfolio From Volatility

Is it possible to gauge the level of anxiety in the investment markets? Certainly, and The Chicago Board of Exchange Volatility Index (VIX) measures it. The VIX reacts in real time - just as a stock does - and measures the level of volatility in the U.S. markets over the next 30 days. When the VIX is at 30, in the next 30 days the market could move as much as 2.5% in either direction, (30% divided by 12 months equals 2.5%). The VIX has hovered around 30 for the latter part of 2011, indicating that the market is still highly volatile.

Although short-term traders may call periods of high volatility great times to make money, the truth is that traders of all skill levels will face challenges in this market. What can you do to protect your portfolio against the wild stock market swings? Though it may not sound exciting to the average active trader, the best defense is to stick with conservative, "boring" strategies.



Hedge
Think of hedging as an insurance policy. Let's assume that you own Bank of America stock and it is now in a market decline. One way to hedge would be to purchase a put option, with a strike price below where you purchased the stock. You won't lose money on any move below your strike price. Other hedging options include short selling a stock and purchasing put options on index funds, like popular exchange traded fund SPDR S&P 500(NYSEArca:SPY). (To learn more on hedging, read Hedging Basics: What Is A Hedge?)

Low Beta
Beta is the measure of volatility in a particular security. If a stock has a beta of one, expect it to move at the same rate as the S&P 500. A stock with a beta below 1.0 is less volatile than the market index; a beta that is higher is more volatile. In times of extreme market volatility, concentrate on low beta stocks that pay a dividend. (For more on this volatility measure, read Beta: Know The Risk.)

Stay Out
At the end of 2011, the market saw trading volume substantially drop. Some market insiders attributed this to professional investors who were tired of the whipsaw action of the stock market, so they took some of their money out of the market, determined to wait until the VIX went down.

Retail investors who are trading in the market have to know when the market is too volatile and exit into safe haven investments. Investors who have long-term portfolios should not do anything. The market will stabilize, but until then, rely on dividends for safe, consistent income.

Stick with the Index
Efficient market hypothesis (EMH) is a theory that states that it's impossible to beat the overall market. This means that individual stock picking will not yield better results over the long term, so investing in an index fund is the statistical best way to make money, especially in times of extreme volatility. Don't expect stocks to act rationally; consider staying with the index. (To learn more on the history of indexes, check out How Stock Market Indexes Changed Investing.)

Increase Your Time Horizon
Times like these make trading a losing game for many. Until the markets calm down, consider increasing your time horizon. Find an undervalued stock or buy an index fund when the market is at the bottom of its range. Commit to holding the position for at least a year, unless something drastic happens. The longer you invest, the easier it is to make money. Remember, every dividend payment decreases the cost basis of your stock.

The Bottom Line
Professional investors know that often the best action is the lack of action. Don't respond to the markets; position yourself with a long-term portfolio that can set you up for any type of market.