By Dr. James M. Dahle, WCI Founder

As a speculative frenzy or mania builds, many investors start considering ways to protect their portfolio from a market crash. Sometimes this involves a change in asset allocation. However, there are a few considerations you should make before actually doing anything.

In my experience, beginning investors have trouble staying the course with their investing plan at market bottoms. They panic sell, completing the devastating buy-high, sell-low cycle that investors are famous for. However, intermediate investors seem to be susceptible to problems at the other end of the cycle. They have trouble staying the course at market highs. They panic when the market hits new highs week after week, not realizing that is a normal part of market cycles. The market is actually near or at all-time highs most of the time. So they sell out early and miss out on receiving the entire upside of a bull market. Advanced investors have seen both of those movies before and know how they end. They take a long-term perspective and stick with their plan.

However, there are times when an asset allocation shift is reasonable because of changes in your life or in your investments.  For example, if a recent bull market has enabled you to reach “enough” or made it so you no longer need to take so much risk with your portfolio, it's reasonable to dial it back. Not because you think the market is about to go down, but simply because you don't need to take that kind of risk anymore to reach your goals. Bernstein is famous for describing this situation: “When you find you have won the game, stop playing.”

Likewise, due to a massive speculative run-up, perhaps an investment no longer promises any sort of a reasonable return going forward. Maybe it is because of astronomical Price/Equity ratios or ridiculously low bond yields. You need to be careful with this, because one can justify just about any kind of irrational, emotional investing behavior this way.

Identifying a frenzy in advance is not particularly difficult if you are familiar with financial history. Knowing when it ends, however, is very difficult and often requires a functioning crystal ball. Bill Bernstein has given four criteria for identifying a market mania, and suggests the time to be careful is when you have seen three of the four:

  1. Everyone around you is talking about stocks (or real estate or whatever the fad asset of the day is). And you should really start worrying when the people talking about getting rich in certain areas of the market don’t have a background in finance.
  2. When people begin quitting their jobs to day trade or become a mortgage broker.
  3. When someone exhibits skepticism about the prospects for stocks and people don’t just disagree with them, but they do so vehemently and tell them they’re an idiot for not understanding things.
  4. When you start to see extreme predictions. The example Bernstein gives is how the best-selling investment book in 1999 was Dow 36,000.

I'm not sure I've seen all of these in a single asset class in the last few months, but I have certainly seen all four.

  1. During the Wall Street Bets/Gamestop short squeeze mania all of the news outlets, politicians, and random people were talking about stocks. The first investment for many people was GME stock, just in time for it to crash back down. Likewise, every time Bitcoin spikes, I hear nurses in the ER talking about it.
  2. More recently, I have seen people who have either quit their jobs, been fired, or who are simply home a lot more often day trading or gambling in the markets. Witness how Wall Street Bets had so many people sign up for their subreddit that the moderators couldn't even read all of the posts, much less moderate them.
  3. Want to be told you're an idiot? Publicly suggest even a tiny amount of skepticism about buying a cryptocurrency that went up 1000% in the last year. Or that SPACs are similar to that company in the South Sea Bubble that was “For carrying-on an undertaking of great advantage but no-one to know what it is.”
  4. Trees don't grow to the sky and stocks don't go “to the moon”, despite how many people think they will. Citi analysts are predicting $300,000 Bitcoin by the end of 2021. That's basically taking something that went up 1000% last year and predicting it will do it again the next year.

Certainly lots of reasons to be cautious out there. The difficulty, of course, is determining whether we are in the equivalent of 1996 or 1999. Good luck with that.

 

7 Hedges Against a Stock Market Crash

So today, I wanted to explain seven ways that you can protect your portfolio from a market crash. Note that these methods are not all equal. In fact, some of them I wouldn't touch with a 10-foot pole. But they do have the potential to protect you. If you choose to use one of these, I would encourage you to include exactly how you are going to do so in your written investing plan. Emotion and rapid movement is the enemy of a sound investing plan.

 

#1 Future Earnings

Perhaps the greatest protection is knowing that the vast majority of the money you will invest in your lifetime has not yet been earned. Young investors should get down on their knees and pray for a bear market, allowing them to acquire the shares of the world's most profitable companies at a discount. A 70-year-old might not feel that way, but a 25-year old should. If you have a $50,000 portfolio and are earning $200,000 a year, a market crash is no tragedy at all. Your retirement nest egg is almost completely protected because it isn't in the market yet. It hasn't even been earned yet.

 

#2 Different Kinds of Stocks

Sometimes the overall market crashes or just one sector crashes, leaving other types of stocks to do quite well. Ben Carlson recently argued that there are a lot of investments that aren't in a bubble right now, despite the run-up in the large growth stocks that dominate our current market. He listed emerging markets, European stocks, Japanese stocks, value stocks, energy stocks, and financial stocks. If you recall the 2000-2002 market crash, small-value stocks came out smelling like a rose. There is no guarantee that will happen again, but diversifying among stocks certainly has potential to protect your portfolio. I do this in my portfolio by owning international stocks, small-value stocks, and REITs. All of those have caused my portfolio to lag behind the S&P 500 (tracking error) the last few years, but in a market downturn, they could make all the difference. Diversifying like this, of course, is the exact opposite of doubling down on tech stocks by dedicating a 5% portion of your portfolio to the tech sector, buying ARK funds or QQQ, or buying individual shares of the most popular stocks. Consider the following correlations with the overall market:

  • 500 Index 0.99
  • Value Index 0.95
  • Small Value Index 0.93
  • Financials 0.90
  • International Stocks 0.80
  • Emerging Markets 0.68
  • Energy 0.70
  • REITs 0.46

The lower the correlation, the more you are likely to benefit in a market downturn, but the higher your tracking error will be.

 

Stock market crash

We all know a crash is coming, it's just a matter of when.

#3 Fixed Income

The classic diversifier for a stock portfolio is fixed income. This ranges from long-term bonds to cash. The further left you are on that spectrum, the more interest rate risk you are running. If we're talking about nominal bonds, there is also more inflation risk on that side of the spectrum. However, in a stock market downturn, long-term treasuries often perform very well. While different types of stocks may be less correlated with your stock portfolio, bonds are generally uncorrelated or even negatively correlated with your stocks. Consider the following correlations:

  • Long-Term Treasuries -0.39
  • Intermediate-Term Treasuries -0.03
  • Short-Term Treasuries 0.13
  • TIPS 0.03
  • Long-Term Corporates -0.05
  • Intermediate-Term Corporates 0.21
  • Short-Term Corporates 0.40
  • High-Yield (Junk) Bonds 0.62

Remember that corporate bonds take on some equity risk. In normal times, this causes their yield to be higher, but it also results in higher correlation with your stocks in a market crash. For example, in the first quarter of 2020 (the COVID-related crash), the Vanguard Intermediate Corporate Bond Index Fund lost 3.99% while the Vanguard Intermediate Treasury Fund made 6.73%.

 

#4 Other Investments

Another way to hedge against a stock market decline is to simply have your money in something besides stocks. There are obviously downsides to not investing in the most profitable companies in the history of the world. The main one is you don't get to participate in the good times, which is actually most of the time. But you can't lose money in stocks when that money isn't invested in stocks. So lots of people “hedge their bets” by adding other “alternative” asset classes to their portfolios. We already mentioned fixed income investments above, but there are other types of both productive and non-productive (speculative) assets out there. Here are some of the most popular ones:

 

Income-producing real estate

While in an economic downturn both stocks and real estate can fall in value, the normal response to a crashing stock market (cutting interest rates) is actually very beneficial to real estate investors. High returns and low correlation to stocks is a great combination. Even the Vanguard REIT index (real estate flavored stock) has only a moderate correlation to the overall market.

 

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Precious metals

Volatile with historical real (after-inflation) returns of 0%, gold and silver may not be everyone's cup of tea. But once or twice a generation, especially in times of high inflation, investors seem to flock to the metals in a way that justifies holding a small percentage of the portfolio in them for the long term.

 

Cryptocurrency

A very popular asset class after extremely strong returns over the last decade, some argue that Bitcoin is digital gold. Others argue that the true value of Bitcoin is to divide up the value of the entire world by the 17 million Bitcoin that have not yet been lost, suggesting a price of

$256 trillion/17 million Bitcoin = $15 Million per Bitcoin

Which is obviously dramatically higher than whatever it is trading at today.

Skeptics argue that Bitcoin is still not a useful currency or even a reasonable store of value given its extreme volatility, pointing out that there are 4,000 other cryptocurrencies out there and they can't all be worth $256 trillion each.

Personally, I have no idea what the true value of a Bitcoin is, but I do know that in its short history it doesn't seem to be correlated to stocks, bonds, gold, or the price of butter in Bangladesh. If you want a non-correlating asset in your portfolio, cryptocurrency certainly qualifies.

 

Commodities

Oil, gas, wheat, coffee, sugar, cotton, and corn, among others, are commodities. There are numerous ways to invest in them (most conveniently via derivatives) and they tend to do well in inflationary times. Which explains why commodity ETFs like GSG have 10-year returns of -8.63% per year. But the correlation with stocks of this speculative asset is definitely low to negative.

 

Art and Collectibles

I understand most of the world's expensive art is not on display in any museum or even anybody's house. It is held in storage as a hedge against market downturns. Like all collectibles (including precious metals but not cryptocurrency), gains are subject to a higher tax rate than the long-term capital gains rates. You can buy art at auction or even via a private fund. It's only a matter of time before a publicly-traded art ETF shows up. The long-term returns thrown around are 5-7.5% a year, but my understanding is that the most expensive art may have even higher returns.

 

Small Businesses

Successful entrepreneurs tend to have most of their net worth in their own companies. Sometimes you may also have opportunities to invest in the companies of others. Returns can range from terrible to spectacular, but correlations with the overall market are definitely low. For all the talk about our portfolio, guess where most of our net worth is? Some highly-risky, non-diversified, little website.

 

#5 Market Timing

One way to hedge against stock market declines is to get out before or as the market falls. This is a perilous task. Not only do you introduce additional expenses (transaction costs like commissions and bid-ask spreads), but in a taxable account, you also increase your tax drag. Most investors do this (unsuccessfully) in an emotional, irrational way, reacting to news reports and the investors around them. However, a few people actually have a market timing component written into their investing plan that is logical and systematic. Most of these involve following moving averages. There are three downsides to using a moving average as a market timing indicator:

  • You generally catch the beginning of a market crash.
  • You generally miss the beginning of a recovery.
  • You can get “whipsawed” with rapid market changes, causing you to repeatedly buy high and sell low.

If you're interested in this sort of thing, you can read more here. I don't engage in market timing, though. For me and my lifestyle, the downsides of constantly monitoring the market outweigh any potential upside.

 

#6 Short the Market

Speaking of things I don't do, shorting the market is one of the easiest ways to make money when the market falls. When you short the market, you borrow a stock from someone else to sell it. Then, after the price falls, you buy the stock and pay back the person you borrowed it from. Obviously, you have to pay interest on what you borrowed. Plus, via intermediaries, the lender of the stock demands you keep some cash on deposit to protect them from you defaulting, kind of like Private Mortgage Insurance. You generally short stocks in a margin account, which you can actually open right at Vanguard and short the Total Stock Market ETF. The biggest risk used to be that the market could move against you causing you to have to sell low and buy high. However, since millions of Redditors started looking at what is being shorted, maybe your biggest risk now is that there are lots of people out there who just want to watch the world burn even if it costs them their life savings to do so (YOLO!). In a short squeeze, you may have to deposit so much money to protect the lender that you get to learn that the market can remain irrational longer than you can remain solvent. When you are “long” a stock, you can always just hold. Maybe you lose your entire investment, but that's it. When you short a stock, you can lose far more than your investment. You can lose your entire net worth and be forced into bankruptcy.

 

#7 Puts

If you're really sure the market is going to go down soon, there is an even more profitable way to bet against it. You can buy a type of option called a “put”. A put option gives you the right, but not the obligation, to sell a stock (or an ETF) at a specific price (the strike price) by a specific time (the expiration date of the option). In exchange for this right, you pay the seller of this option a premium. If the price of the stock doesn't fall, you lose your entire investment (the premium). If it does fall, you can massively profit, especially if you correctly bet that a stock will soon crash hard when nobody else thought it would do so. With a put option, you control many shares of stock for a relatively small amount of money.

For example, for $500 you may buy the option to “put” 100 shares of a stock to the seller at a certain price. Let's say the stock today is $100 a share. And you buy a put option with a strike price of $95. You are buying an “out of the money” put. If the price of the stock falls to $95, you haven't yet made any money. You're still out your premium. But if the stock falls any further, you're going to start making money and fast. If it falls to $50 a share, you now have the ability to go out and buy 100 shares of stock at $50 a share ($5,000) and sell them to the poor schmuck who sold you this option (just hoping to make an easy $500) for $9,500. So you made $4,500 on your initial investment of $500, a 9X return. Now, instead of just buying $500 worth of options, let's say you bought $100,000 of options. You just turned that into $900,o00 in a few weeks. As you can see, if you have a clear crystal ball, options are the way to maximize the value of your foresight. If you don't have a clear crystal ball, options are a good way to lose your entire investment.

I only made the mistake of dabbling in options once, with my very first investment as a teenager (thanks dad's friend!)—yes, I lost my entire $500. And that's a lot of money to a kid who cried when he lost a $5 bill on the way to the grocery store to buy candy.

Nevertheless, if you want to hedge against a market decline, put options certainly work. There are valid business uses of options, futures contracts, and other derivatives. They allow a farmer to hedge against unpredictable weather and insects. They allow an airline to hedge against a rise in the cost of oil. Sometimes people want to lock in their investment gains while waiting long enough to pay long-term capital gains taxes instead of short-term capital gains taxes. But most of the activity in derivative markets is purely speculative. When you win, someone else loses and the overall expected return after costs is negative. I would avoid it.

There is a market decline coming. I don't know when it will come. I don't know how big it will be. I don't know how long it will take to recover. If you want to hedge against the possibility, pick your poison from the seven choices above. Otherwise, do what I do and just ride it out remembering that “this too shall pass” and that your investment horizon is much longer than the longest bull market we have experienced yet.

What do you think? Which of these methods do you use to hedge against a market crash? Comment below!