Why You Should Over Protect Your Investments
“Zach, when the next hurricane hits, this place is going to be in a world of hurt.”
That’s what my friend Erick had to say as we drove over the Sea Island causeway yesterday afternoon. I’m on vacation with my family this week, enjoying some quiet beach time at one of our favorite getaways. Erick is a friend who lives nearby and took some time to come visit with us.
While the Sea Island Cloister is built to withstand anything the weather throws at it, and the Georgia coastline is naturally protected, Erick’s statement got me thinking about the importance of protecting your investments to weather an economic storm.
The Difference Between “Adequate” Protection and “Over” Protection
Not long ago, I wrote about how to hedge your portfolio by purchasing “market insurance contracts.” My suggestion was to buy long-term index puts to hedge the investments you make in your portfolio.
Here’s a quick rundown of the math…
If you buy a nine-month DIA $180 put, you’re buying the right to sell shares of DIA at $180.
If the U.S. stock market trades sharply lower, this right to sell shares at a set price will become much more valuable.
Remember, each put contract represents 100 shares. So if you have the right to sell 100 shares of DIA at $180, you’re essentially buying an insurance contract to protect $18,000 of investments. (This is a rough estimation and there are a number of variables that could help you get a more specific estimation.)
100 Shares of DIA times $180 per share = $18,000 of protection
To take this a bit farther, if you had a portfolio with $100,000 worth of blue chip stocks, you could effectively hedge most of your risk by purchasing six of these DIA contracts. (6 times 100 shares times $180 per share = $108,000.)
Today, I want you to consider three reasons you might want to over protect your investments by purchasing more long-term index put contracts. So if you had a $100,000 portfolio of stocks, you might want to purchase 10 or more contracts.
This way if the market trades lower, you not only protect the value of your account, you actually make more profits from lower stock prices.
Here are three reasons why I use this approach in my own account and why you should consider using it in yours:
Reason #1: Because it’s Cheap!
Any time you buy an insurance contract to protect your assets, you have to pay a premium. Buying long-term index puts to protect your investments is no different.
But there are times when insurance is expensive, and times when insurance is cheap.
Right now, with stocks trading near all-time highs, it’s extremely cheap to hedge your portfolio. Just take a look at the chart below.
This is a chart of the CBOE Volatility Index (VIX). The higher the VIX reading, the more investors have to pay to buy put contracts as insurance.
As you can see, the index spiked earlier in the month. But today, the VIX is very low once again. This gives you a great opportunity to buy more long-term put contracts. That way you can over protect your investments at a very reasonable cost.
Reason #2: A Market Crash Could Hurt You In Other Ways
Think about how a bear market might affect your life.
Sure, your investment account may decline in value. But there’s much more to the story.
If we have an extended bear market, the value of your home may decline. Your employer may not be able to offer you a raise — even if you’re doing great work! If you’re retired and make some extra money on the side, you may not have as many opportunities.
As a father, I’ve thought about this a lot. It’s my job to provide for my family, and one of the ways that I generate income is to write investment newsletters. Even though I plan to protect my readers from a market decline, the fact is that few investors want to subscribe to newsletters during a market decline.
So if a bear market hits, I need to not only protect my investments. I also need to protect my earnings. Chances are good that you’re in the same boat.
That’s why I think it is very important to not just protect your investments by purchasing market insurance, but to also protect your livelihood by adding extra put contracts.
Reason #3: Take Advantage of Bear Market Opportunities
Yesterday, I took an afternoon walk on the beach and the house you see on the right caught my attention.
This house has it’s own private path to the beach, spacious living area, a pool, a yard for kids to play in, and it’s within walking distance of the Sea Island beach club.
My guess is that this house would retail for something north of $15 million. But during bear markets, interesting things can happen to luxury real estate properties. Since most of these properties are “optional” to own, and since many luxury real estate owners are deeply in debt and over-extended, unique opportunities can arise.
Would I like to own a beach house like the one pictured above? Not necessarily.
But I do like the idea of having extra spending money during a bear market. This way, whether I’m shopping for real estate, buying a small business, or just investing in new stock opportunities, I’ll have extra money to spend.
That’s the beauty of over-hedging your investments. If you buy more long-term index puts than you actually need, you’ll have extra cash to spend in a bear market. And when a bear market hits, you can get often get ridiculously good deals on investment opportunities.
Of course you need to use wisdom when deciding how much to spend on long-term index puts. I don’t want you to spend so much on insurance that you offset all of the investment income you’re generating.
But I do think now is a perfect time to invest a bit more to protect your investments, so you’re in great shape when a market decline hits.