Protecting Your Portfolio From Yourself

 | Jun 13, 2012 | 11:30 AM EDT  | Comments
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Stock quotes in this article:

spy

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MINT

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HDGE

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BTAL

Over the past couple of months, many investors have learned that they simply don't have the stomach for volatility that occasionally roils markets. As I've been writing about here, a mismatch between your portfolio's risk profile and your personal willingness (not to be confused with ability) to take risk can be a recipe for disaster. When stocks crater, the risk-averse investor in all of us develops a strong desire to cut losses, move to cash and "ride out the storm" from the calm of a safe haven. But unfortunately, in many instances, it doesn't quite work out that way. We have a knack for selling low and buying high -- the exact opposite of the ideal strategy.

The recent chaos in markets serves as an excellent illustration. Between May 1 and June 1, the SPDR S&P 500 (SPY) lost about 9% of its value. That free fall no doubt caused many investors to question their strategy, fear that the sky is falling and pull out of risky assets until they felt better about the economic environment. We all know what happened next: Stocks went on a rally, and SPY has since added about 4%. It's still well below April levels, but the recent bounce-back helped to erase a lot of the pain -- unless, of course, you were watching the rally from the sidelines. In that case it was a double-whammy, and one that has put you far behind the curve in terms of your portfolio.

My point is that volatility in markets makes us do things that seem foolish in hindsight. That's especially the case when investors build portfolios that take on more risk than they personally are willing to stomach. So I view risk management as being a very important process of managing your portfolio. Not only does it have the direct, measurable benefit of limiting losses, but it can also be seen as a way for investors to protect portfolios from their worst enemies -- themselves.

For those of you who have recently discovered your aversion to big swings in the value of your portfolio, I'll present a few funds that can be extremely effective at smoothing out the ups and downs.

PIMCO Enhanced Short Maturity Strategy Fund (MINT): This ETF is one of the ultimate safe havens, focusing on short-duration, high-quality bonds. The result is an ETF with ultra-low volatility. MINT will generally stay within a very narrow band, and it seldom loses more than a few basis points in a single day.

Active Bear ETF (HDGE): This ETF consists of short exposure to U.S. stocks, meaning it should bring some meaningful diversification benefits through a strong negative correlation to stocks. HDGE is built around the concept of forensic accounting. It attempts to short stocks that are aggressive with their accounting and could be setting themselves up for a big decline in share price. Because this fund's best days will tend to be when the markets are sliding, this ETF can be a great way to smooth out overall portfolio volatility.

Market Neutral Anti-Beta Fund (BTAL): This ETF combines long positions in low-beta stocks with short positions in high beta stocks, delivering a market-neutral portfolio that tends to perform relatively well in tumultuous environments. Because the exposure maintained is "net zero," BTAL can be expected to exhibit very low overall volatility. Further, because of its tilt toward relatively stable stocks and away from riskier ones, it will generally post positive returns when the broader market moves lower. During rough patches, that will have the benefit of lowering overall volatility, sometimes by much more than investors might expect.

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