Investing is an emotional exercise. This past week on Wall Street proved that point yet again. With new cases of Covid-19 (Coronavirus) being reported in multiple countries, the market went into a tailspin. The S&P 500 fell by more than 11% and $7 trillion in market value disappeared in under five days. What began as cautious hedging on Monday ballooned into a fear-based sell-off by week’s end.
It doesn’t have to be this way. Yes, a pandemic that has killed over three thousand people is worthy of our attention. No, you do not have to lose your retirement nest egg over the economic volatility the epidemic is causing around the world. A simple hedging strategy to manage downside can ensure your portfolio remains intact.
Lessons from the Past can Preserve our Future
We have been here before. The last time the market declined at this rate was, you guessed it, in 2008. That could instill more fear in you, or it might inspire some hope, because we did turn things around in the past decade and our 401K’s are fat again. If you’re in your thirties right now and you’re not all that concerned about recent losses, stand pat, rely on history, and you “might” be fine. I wouldn’t recommend it though.
If you’re planning on retiring soon, you need a better strategy now. The typical 60/40 portfolio in 2008 dropped 22% and took years to recover. Those in their fifties and early sixties don’t have time to wait for that. Don’t get me wrong. I’m not preaching doom and gloom here. A vaccine could be developed in the next month and all will be right in the world, but how long will it take to recover from the economic impact we’re facing right now?
Seeking Out Lower Volatility and Higher Dividend Yields
The stocks that are classified as “Blue Chip” typically have lower volatility and pay out higher dividend yields. The “ultras” in this class are familiar household names. Chevron, Coca-Cola, Disney, PepsiCo, Walmart, and IBM are all in this category. FAANG stocks like Amazon, Alphabet, and Google also fit the description. These are all multi-national corporations with a history of stability, so they are generally solid investments.
The volatility of equities (stocks) is determined by a number known as the “weighted average beta.” I won’t bore you with the math, but what you’re looking for is a beta number that is under 1.0. That indicates low volatility. A well-constructed “basket” of ultra blue chips should have a beta under .70, meaning losses will be 70% of what the S&P loses.
Blue chips also offer higher dividend yields. In the case of our hypothetical basket above, the dividend yield is 3.12%. Historically, 40% of the S&P 500’s returns come from dividends. By using this strategy as the foundation of your portfolio, your downside is minimized, and your dividend yield will be higher and more consistent.
Utilizing Options for Additional Protection
Choosing the right stocks to invest in is only one piece of constructing a winning portfolio. We use “index put options” to ensure our downside management strategy is multi-layered. For those outside the financial services field, a “put” option is an option to sell at a certain price. An “index put option” is not an option on a specific stock, but on the index itself. For instance, if you have an index put option on the S&P 500 and that index goes down, you’re protected.
That’s a fairly simplistic explanation. Options come in all shapes and sizes and typically have a window of time in which they need to be exercised. There’s also a specific technique we use for purchasing options, which is determined by the beta of the portfolios we put together. I’ll be publishing more on this in the upcoming weeks. Make sure you subscribe to my blog so you don’t miss any of these valuable updates as we go through this volatile economic period.