Author: Simon Moore
Stock-market crashes come along every few years. Academics have recently analyzed a number of ways to protect yourself the next time markets hit a big drop. There’s a clear trade-off between the cost of an approach and the reliability of the protection in any given crash. Here we’ll run through what the researchers found.
Crashes Are Uncommon, But Can Be Costly
Researcher Campbell Harvey of Duke University and others affiliated with Man Group published their research here. The first thing to note is that though stock-market crises grab our attention they are not all that common. About 86% of the time markets trend in a positive direction. Nonetheless, steep market falls, which the researchers classify as a stock market fall of 15% or more can be extremely painful to investors. Even worse, these falls can push investors out of the market through fear, which may mean they are slow to get back in, missing future gains.
Put Options Work, But At Cost
There is a trade-off between a strategy’s reliability and its ongoing cost. For example, two of the most reliable ways to protect yourself in a weak market are to own put options or to short credit risk. Unfortunately, both of these strategies tend to lose you about 10% to 15% a year in normal markets over recent decades. So yes, you get reliable protection, but it comes at a cost. The cost is that your returns will be significantly lower overall if you use this strategy, at least if recent history is any guide.
Bonds And Gold Can Help, But Are Less Reliable
Long-term bonds and gold have historically been positive return investments. This means that, unlike put options, they have historically grown in value in recent decades. For long bonds, returns have been about 4% a year, for gold returns are closer to 1%. Note that where long bonds are trading today it seems unlikely they’ll deliver 4% returns going forward, as the current yields are under 2% for 10-year Treasury bonds. Still, in bad market environment bonds and long bonds have offered protection in about eight of ten historic crises. That’s not bad. Bonds and gold do a reasonable job of shoring up your returns in bad markets but also potentially offering a positive return in more favorable markets.
Momentum As A Winning Strategy
The researchers find clear support for momentum strategies. The researchers test multiple variants of momentum but generally find that it not only provides returns in strong markets but can also fare well in poor markets. This is because momentum is, buying what is currently working, and selling what isn’t. As such it can help keep up with positive markets, but also react quickly to changing markets. Like bonds and gold, not all momentum strategies work reliably in bad markets, but more often than not they are a help.
A Bias To Quality
The last broad category of strategies that the authors support as a source of portfolio protection is to include quality stocks in portfolios. Quality stocks can be defined in multiple ways. They are typically more profitable, less volatile, see better profit growth and payout more to shareholders than average. Again, these strategies have the desirable property that they can do well in good markets too, but the trade-off they are somewhat less likely to perform reliably in bad markets.
Actions For Your Portfolio
So if you are worried about the next market fall, then long bonds and gold are sensible assets to consider for your portfolio. They won’t help in every crash, but history is on your side. Of course, put options and shorting credit risk is even more reliable as protection when markets drop. Yet, you are historically paying a real cost to hold these assets, if history is any guide, which can easily eat into your returns.
Finally, the best of both worlds may be taking a deeper look at momentum and quality strategies within your stock portfolio. Both have the potential to augment returns in good markets and can add support in weaker markets.