With all the market ups and downs over the past two years, most investors are learning to live with some measure of market volatility. But how can investors defend themselves against a 1,000-point drop that, in fifteen minutes, shook the markets last week?
"I was out of the office traveling and when I got on the plane the market was down nine -- I got off the plane, it was down 800," says Cameron Short, a senior vice president at brokerage and investment banking firm Stifel Nicolaus.
Short says that although a technical glitch probably contributed to the market gyrations on May 6, market swings will always play havoc with investor portfolios unless investors take proactive measures to limit their losses. While converting everything to cash could be considered a defensive position, the return on that maneuver would not good and the fees involved could be expensive. Here are some strategies that Short and other money managers say investors can use to defend their portfolios from market mayhem:
Have a rebalancing strategy. Short says people rebalance when they are fearful, not when the market is rising comfortably. He suggests investors rebalance quarterly, semi-annually or annually, depending on the type of portfolio and the type of assets you have. Rebalancing helps you stick to the asset allocation model that is appropriate for your situation instead of allowing some assets to become too heavily weighted in the portfolio, thus adding risk.
"Rebalance and make sure that [your asset allocation] is where it should be instead of letting it ride," he says.
Only buy short-duration bonds. Short advises investors not to buy any bonds or fixed income investments with maturities longer than five years. He prefers high quality short duration municipal bonds and corporate bonds. Based on the yield curve which did not forecast a strong year for bonds, there is too much risk in longer term fixed income securities.
"I'd definitely consider short, high-grade corporates as a good alternative to government agencies right now," he said.
Diversify asset classes to limit risk. "We're not going to allow any one sector to be more than 25% to 30% of a portfolio. That may be a little high for some people and we're not going to allow any one position to be any more than 5% to 7% of the portfolio," Short recommends. "That's a great way of keeping responsible diversification."
He also advocates having some exposure to commodities and real estate investment trusts (REIT) – as much risk as the client is willing to take.
Use Stop Orders. Maury Fertig, chief investment officer of Relative Value Partners, advises clients to use stop orders to limit losses on a single investment to an amount you are comfortable with. Stop orders allow you to buy or sell a stock at a specified price. A buy stop order or sell stop order can help an investor limit the loss or protect the profit made on a particular security.
"Last week certainly was not healthy for investors," says Fertig. "But for most investors, if you operate with limit orders which allow you to stop losses, [volatility] won't affect you [much]."
Use an "Absolute Return" Strategy. Fertig also uses an Absolute Return Strategy for his clients that he says "is designed to generate a positive return over time irrespective of what the market is doing."
Fertig develops an individual absolute return strategy for each individual client based on the types of mutual funds and other investments they hold in their portfolio. Since 2006, his firm has an average annualized return of just over 10%.
Fertig says using an absolute return strategy for at least 10% of your assets "takes some of the downside risk out of your portfolio. It's an alternative strategy to get a moderate return without a lot of downside."
There are so-called absolute return mutual funds that investors can use to get positive returns in volatile markets. Fertig recommends the Gabelli Global Deal Fund (GDL) which is up 9% year-to-date, and The Merger Fund (MERFX), which is up only 0.84% for the year.
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