Hedging
The term hedging can refer to a variety of ways to protect against stock declines. One common method involves using options contracts to bet against individual stocks or the broad market. In a crash, the stocks lose money, but the options can offset those losses. It's like insurance.
The problem: When a homeowner buys property insurance, he gets full protection that costs, in many cases, less than 1% of his house value per year. For an individual stock investor to buy that level of protection could cost more than 5% a year -- enough to more than erase the S&P 500's gain from the past five years. He could buy a short-term hedge, but someone who knows just when stocks will tank doesn't need hedging.
Some safeguards are free, however, like the combination of time and cash. If the stock market slides next week, companies will continue to produce profits and even pay dividends. Those dividend payments will gradually offset price declines, and investors who reinvest them into more shares will benefit doubly from the eventual recovery in share prices.
To wait out a downturn, investors must be able to pay their living expenses. Cash and bond income will help with that. Conservative investors should have easily accessible savings that will pay the bills for six months, along with 40% or more of their portfolio in bonds.
Of course, some investors can't afford a five- or 10-year downturn in the stock market, no matter their allocation to cash and bonds. They should avoid stocks.
Defensive investing
"Defensive" investing refers to buying investments that tend to hold up well during times of financial stress. For example, if a recession strikes, Caterpillar (CAT), whose equipment sales depend on demand for new construction, might fare less well than General Mills (GIS), whose cereal sales depend on demand for breakfast.
But stock returns depend largely on the price investors pay, and defensive companies can get expensive during periods of high investor anxiety. General Mills now costs 60% more than Caterpillar relative to trailing earnings.
Truly defensive investing involves checking the valuation, not just the sector. Fast-growing companies are sometimes worth premium prices. But at the moment, the priciest S&P 500 sectors relative to next year's projected earnings are steady, slow-growth ones: consumer staples, telecom and utilities.
That is a sign that truly defensive investors should look beyond traditionally defensive stocks.
Stocks mentioned on the previous page include Consolidated Edison (ED), Coach (COH) and Google (GOOG).
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