Risk
How to Protect Your Investment Portfolio and Mitigate Downside Risk
by Peter Cohen (Write for us!)
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Investing your life's savings is different from investing speculative assets. For
core assets, assets you can not afford to lose, safety becomes as important as growth. However, in order to capture growth one must invest in equities. Yet the more an investor places in stocks, the more the investor increases his risk. Diversification along various asset classes might reduce risk somewhat, but the cost of taking more assets away from stocks by investing in bonds and money instruments leads to the possibility of significant underperformance in strong and rising equity markets.
The challenge, therefore, is how to invest and participate in the stock market and mitigate downside risk. This is not a unique challenge. Most investors want growth but are unwilling to accept or unable to experience a significant loss in value. These
investors have overcome this challenge by agreeing to exchange a portion of their portfolio's upside potential for a reduction of risk in a declining market.
So what can we do to earn more than 5% on our longer-term money for the foreseeable future? And worse, how do we avoid a 0% - 2% world with our super-size money? Beyond that, what can we do to beat those returns, with the potential for substantial upside?
Normally, you'd say there is no way we can "cheat the markets". What the market is paying is what you're getting. That's usually true, except when a risk management strategy or "portfolio protection" strategy is added.
For many years, institutional investors have used put options within equity portfolios in order to mitigate downside risk. In 1998, Congress eliminated the obscure "short short" rule from mutual funds. At that time, GE Private Asset Management created a unique fund (contra) to hold a portfolio of put options to create a "hedge" for stocks and mutual funds which
they manage for clients. In other words, a risk management strategy.
I call it the Jack Welch protection strategy. Puts can provide dollar-for-dollar protection for the portfolio when the market declines, but they do not lose value proportionately when the market rises.
The use of puts has several powerful advantages: In short, the GE Contra Fund and risk management strategy, when matched with an invested equity portfolio, helps an investor have protection while still participating in major market upswings.
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