7 Steps to De-Risk Your Portfolio

Today’s financial markets are filled with extended, illiquid, and overvalued securities. Its not just individual stocks and bonds, but the closed-end, mutual and exchange traded funds as well. Investors, especially those approaching retirement, should consider reducing risk in their investment portfolios. Here are 7 Steps to De-Risk Your Portfolio:

Step 1- Get off of Margin

The first thing you need to do to de-risk your portfolio is get off of margin. Debt is what causes bubbles to burst. We’ve seen it in the U.S. real estate markets and various equity markets, most recently the Chinese markets. The amount of margin debt on NYSE hit a record of $507 in 2015, which Zerohedge reminds us is almost 50% higher than the before the financial bubble popped in October 2007. This is a worrisome prospect considering some of the stock market peaks we’ve overtaken, including the tech bubble and financial crisis. Further, when you look at free cash or liquidity as a percentage of margin debt it is the lowest level ever-suggesting an extreme complacency in the market.

By having a typical allocation to large cap stocks, the companies you own have already put you on margin. The amount of leverage in their capital structures is very elevated and the buybacks we’ve seen, funded with low cost debt, have made investing in these presumed safe, ‘blue chip‘ stocks anything but. It appears the buyback frenzy may have reached its peak because evidence is starting to surface that default risks are increasing. Expect more of a focus on the top line growth for companies (revenues, the actual business) and not the bottom line (able to be manipulated by financial engineering). When you own the stocks with the amount of debt on the companies balance sheets at these levels, you’ll endure double the sell-off as the companies sell the stock they’ve bought back in follow-on offerings to raise cash.

Step 2- Raise Cash

Once you’re off margin, raising cash is the easiest way to de-risk your portfolio. That is, of course, if you begin liquidating holdings before a severe bear market or crash takes hold. When it does, liquidity will dry up and selling even the most heavily traded investments could prove problematic. Cash is a viable asset class that is grossly under-appreciated. For many Americans, the answer may be selling an annuity or stocks you may have inherited. Raising cash seems so counter intuitive because this investment yields no return (it may even produce a negative return in some countries). Rolling over short-term, cash equivalents such as U.S. T-Bills as interest rates rise, will produce a positive return and help de-risk your portfolio. At this stage, investors should be more concerned with a return of principal, not a return on your principal.

Cash levels are near the lowest in history (for individuals and fund managers alike) so you’ll definitely be in the minority if you raise cash. Money Market Fund (cash) levels relative to S&P 500 market capitalization have been at near-historic lows for over three years and hit a new low in 2015. This complacency is not a safe scenario and should be viewed through a contrarian lens. When you are raising cash, make sure your sweep account is a safe money market fund. This probably means one with the lowest yield. That’s right, lowest. A lower yield means it will be more conservative. Beware of money market funds with the term “prime” or “enhanced” in it. They are probably full of reverse repurchase agreements and other questionable “assets”.

Businesses should also have adequate cash on hand to meet unexpected circumstances. If you already have cash on your balance sheet, great. If your cash is tied up in your accounts receivable, you might consider invoice factoring to unlock some of the capital in your business. You could also consider a sale-leaseback of a building or some other type of equipment.

Step 3- Sell any High-Yield Bonds

There has been volumes of evidence that this is a historic junk bond bubble. Just because it hasn’t popped yet isn’t an excuse to ignore it. The Barclays High-Yield index hit an all-time low of 4.94% in 2014 which is incredible given the fact that our ‘risk-free’ Federal Funds rate was 5% just a few years ago. The level of complacency got so high the market effectively called high yield ‘risk-free’. It won’t be. Credit spreads are already beginning to widen and should blow out as the carnage unfolds. You don’t have to be a part of it.

Our site offers ideas on how to hedge junk bond exposure, but when rates rise not only will credit risks increase but junk bonds will become unattractive on a relative basis compared to safer alternatives, like U.S. Treasuries. Selling your junk bonds now (while there’s still some liquidity to make the sales) will address some tail risk and help de-risk your portfolio.

Step 4- Buy Protective Puts

A ‘protective put’ is a strategy where you buy a put option on a security of which you already own (or something similar). This way, you can hedge that position for a period of time without the hassle of liquidating and possibly needing to get back in.

You might consider buying the longest term put options you can. This will probably be LEAPs on the S&P 500 Depository Receipts or SPY, which seem to have the longest options chains. This will cost more because you’re paying for the options time value, but you’ll be hedged for the longest period of time and won’t have to continuously going into the options markets to continue putting on the hedge.

Also, consider buying put options on anything that relates specifically to you. If you have substantial equity in a profit sharing plan, especially if it’s not vested, you should consider protective put options if it’s not in violation of a company policy. This way, if the company stock you’ve been accumulating over the years becomes worthless (like Lehman’s did for many) you’ll have something to show for it from the gains in the options, which will appreciate in value. Mark Cuban hedged the Yahoo stock he received from his company’s buy-out through put options. If he hadn’t, he’d have lost most of his payday since he was unable to sell his Yahoo stock because it was restricted.

Consider protective put options for anything that’s illiquid in your portfolio or that you can’t short. Protective puts are great for financial stocks because 1- You may not be able to locate the stock to sell 2- If you do locate them. 3- It’ll be less expensive. Financials typically have above average dividend yields and when you short a stock, you owe the dividend. Something like the XLF, with its significant concentration risk, might be a shorting candidate for the right person.

Step 5- Buy an Alternative ETF

The next step in portfolio protection is to get into more defensive holdings, such as alternative or hedged ETFs. There are now several different sub-categories to choose from including low volatility, currency hedged, smart beta and long/short. These funds have held up pretty well in the recent selloffs of August 2015 and January-February 2016. They offer investors alternative asset strategies and non-correlated exposure to the markets. Take a look at our Best Alternative ETFs list for some ideas.

Step 6- Buy an Inverse ETF

Taking the next step in your risk reduction strategy, inverse ETFs can realize significant gains in a strong, downward trending market. They can also be used as intra-day hedges. Not all inverse ETFs are equal and there is no telling how they, or many other investments, will hold up in a severely strained financial system. In August of 2015, they performed quite well and actually outperformed due to the intensity of the sell-off (compounding worked in your favor). If you’ve followed this list we like the PSQ. SH is probably our favorite because it hits a broad representation of the market and has the most liquidity. Please take a look at our other favorites in our Best Inverse ETFs list.

Step 7- Short Selling

Short-selling can be a very profitable trading strategy and can reduce risk in a portfolio. when you short sell a security, you locate it, borrow it, sell it and return it. Hopefully you sell high and buy back low for the trade to be profitable. One nice benefit of shorting-the sale proceeds are credited to your account. Shorting can also be used in pair trade strategy, buying one undervalued security and selling an overvalued one in the same industry. This helps create a market neutral position. If you are thinking about shorting, consider a low-yielding, highly concentrated ETF. This will need to be done in a non-retirement because you won’t be able to short a stock in an IRA because of the theoretically unlimited risk. You may want to try asking a custodian of a self-directed IRA if they allow shorting.

There’s no telling how the stock market crash will unfold but these ideas will give you the best chance to ride out the storm and de-risk your portfolio.