Many investors need equity returns to build wealth over the long term. Unfortunately, as individuals, we sometimes find it difficult to endure the sharp declines that we often experience in the equity markets. This was particularly true from late 1999 through early 2003. As investors, we should understand that risk is necessary to pursue higher returns. However, the correlation between risk and reward illustrates that higher returns, more often than not, experience higher volatility. This leads to the subject of risk management.
Recently, the challenging markets have tested the resolve of many equity investors. Since the markets have begun a major recovery this year, many people want to invest, but with some form of protection to anticipate risk. As we all recognize, the growth of any equity portfolio is highly dependant on the returns of the stock market. If the market falls by a large percentage, as it did between 1999-2002, it is likely that the portfolio will also fall.
Investing one's life savings is different from investing speculative assets. For these core assets, safety becomes as important as growth. Prudent risk management therefore requires that we address the possibility that the current "Bull" market could turn "Bearish" at any time. We don't wish for the markets to turn bearish, but we do want our portfolios to be prepared should unfriendly market conditions occur.
The most common form of risk management is the use of bonds or fixed income to dampen the volatility of stocks. Since bonds are a more conservative investment than stocks, generally speaking, and bond returns are not dependent on stock returns. Many people use bonds to minimize risk. However, both rising interest rates and a rising stock market will generally influence a declining bond market. Many investors use bonds in order to smooth out the roller coaster ride of the stock market over time. The more conservative one is, the more bonds one can place in his or her portfolio. Yet there is another more sophisticated protection mechanism available to investors to mitigate risk.
The risk management strategy that I'm referring to is not the standard diversification or asset allocation. In other words, it is not the proverbial "Don't put all your eggs in one basket" or the spreading of one's portfolio across several different asset categories we've all heard about. We all should pursue diversification but it is the use of a dynamic risk management strategy, that provides this hedging technique. In fact, America's largest institutional investors have used this unique and sophisticated portfolio protection mechanism for a decade. These institutions buy put options, sometimes known as derivatives, to protect their holdings in a declining market. A put option is a contract entitling the holder to sell a designated security at or within a certain period of time at a particular price.
To understand how a put option works to manage portfolio risk, an analogy can be drawn between the behavior of a put option contract on the S&P 500 Index and the fire insurance policy on your house. At the beginning of the year, you pay a premium for the fire insurance policy (just as you would when you buy a put option contract). If no fire occurs (or in the case of the put, the stock market doesn't fall in value) then the fire insurance policy does not pay off (and the put option expires worthless). If, however, you do experience a fire in your home (or the stock market does fall in value) the fire insurance policy pays off. How much? Well, it depends on the deductible and how extensive the damage. The same thing applies to the put option. If the stock market falls, the put option appreciates in value.
Until recently, this sophisticated hedging strategy was only available to large institutional investors. Now one company, GE Private Asset Management (GEPAM) has developed a proprietary hedging strategy known as Actively Managed Protection or the Contra Fund. This fund is only sold within GE's separately managed portfolios for the benefits of their clients. With a small allocation to the Contra, GEPAM goes a considerable distance toward insulating client portfolios from severe declines in the S&P 500. The presence of GE Contra permits clients to continue to make a significant commitment to equities while remaining adequately and reasonably protected from the possibility of a severe market setback.