Today’s Portfolio Protection Demands Creativity

By Louis H-P on September 28, 2020

Ask investors why they need portfolio protection, and they will think first about systematic risk. This makes sense for listed holdings. Yet with all assets classes increasingly becoming eye wateringly expensive, investors may have to come up with creative ideas to protect the value of their stock portfolio. 

How portfolio protection use to work

Historically portfolios had a built in protection in the form of government bonds. During a period of increased volatility when stock markets would fall, government bonds would appreciate as investors sought safety. With government bonds so expensive today, and inflation risk a threat to government bonds, the traditional 60/40 equity/government bond portfolio does not look ideal.

The risk-free rate may have disappeared. 

As a result one has to be increasingly creative to protect one’s portfolio. It helps to understand what you are protecting. You cannot stop volatility, although there are ways of mitigating it. With the valuations of many (if not all?) asset classes looking far too stretched, arguably you should looking to protect your portfolio against losing it altogether.

Holding physical gold

Gold has been on a tear upwards in 2020. We would not want to call what it does next but there may be some use for it yet. Many investors who have profited from the gold investing in 2020 have done so through buying ETFs, but what about holding physical gold? HSBC and JP Morgan are among two banks who have dedicated vaults to holding gold bullion in London among others. Although the gold price has soared in 2020, who knows where asset prices will be in the future. Gold is a precious metal, and as the most precious of all will always keep some value.

Storing gold is expensive and if you accumulate a couple of bars of gold, then they will likely be held by someone else (gold depository). For piece of mind and for your overall portfolio protection, why not store some closer to home? This can be easily achieved by holding some gold coins.

From portfolio protection to pure speculation

As the world increasingly goes online, formerly complex trading instruments become more widely available to learn about and use. Options can be used to protect portfolios from volatility, although in times of increased stress, the explosion in options trading may lead to other risks, which have not yet been identified.

We do not yet know how the many new investors in options trading will react to the market going against them. Remember tomorrow’s risk is one we do not yet know about, so some (somewhat) complex portfolio protection strategies may not work.

Protect your portfolio from the government

It might sound like a perverse headline, but for those with investment portfolios, it is something that will become increasingly important. With some form of wealth tax coming in the form of increased taxes, investors need to consider what can be done to mitigate it’s effect on their portfolios. 

What about buying an accumulation unit of a fund rather than the income one? (Capital gains is lower than income tax). Have you used up all your tax free allowances? With growth likely harder to come by in future, reducing the tax you pay will become an ‘investment win’.

Reduce your costs

As protecting your portfolio becomes harder and somewhat impossible with traditional mitigation means, it pays to ensure your portfolio is as efficient as possible.

Your first port of call, should be to see how much it costs to run your portfolio. If the value of your investments are trending down or the companies are eaking out minor gains, you do not want to find out this is being eaten up by broker fees.

Comparing the annual charge for holding your investments in an online platform is worth it as there are big differences. It is also worth checking the cost per trade and whether you can get a free trade a month.

You may find the annual charge is high but the cost of trade is low which will suit regular traders, whilst buy and hold investors prefer a lower annual charge but do not mind the higher cost of placing a trade as they rarely trade.

Alternative investments

With stock markets having risen so much, many investors are looking to alternative assets to provide safety. Good thinking, but sadly in practice this is hard. The ‘free money’ that quantative easing has created means every asset class is expensive on a long-run average.

For those looking for protection, diversifying the currencies you hold may be your only real option left. Splitting your cash into Euros, Dollars and Sterling is sensible, when one considers both the short-term and long-term risks each of these currencies are exposed to.

Holding a fair part of your assets in cash may also be a good idea. Although vulnerable to inflation, during the March 2020 Coronavrius inspired sell off, only cash seemed to keep its value. US treasuries and gold, both expected to rise in a sell off, actually fell, as investors scrambled for cash. 

Conclusion

With traditional ways of protecting your portfolio no longer prevalent, what you expect from portfolio protection may have to change. Understanding that you will lose money somewhere is a good start. Who knows what the future holds with regard Corona-virus?

Diversifying across all asset classes is one possibility, so whatever happens one part of your portfolio goes up and the other down. Spreading your assets through a sector rotation, without over-exposing yourself to one area, provides a good margin of safety.

At some point, all this free money which has been printed will lead to inflation, not to mention people living longer and needing more to retire. This leads to an increased need for equities within investors portfolio’s, yet they are higher risk! This is typical of the difficult choice that investors have with regard protecting their portfolio today – taking a risk may be the best way of reducing a risk!

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Louis H-P

Louis is a portfolio manager and a trader who brings a wealth of experience in private banking to The Lazy Trader. A fundamentalist and a trouble-shooter, Louis makes a firm contribution to the trading team.

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