I have previously warned that short ETFs [1] won’t save you in a bear market [2]. In fact, they’re likely to increase your losses.
Buying and holding a short ETF to protect your portfolio from share price falls is therefore a bit like getting a man-eating lion to keep away the wolves.
So what can you do if you fear a falling market? Is there any action you can take to reduce or offset the decline in your stock market investments?
Price falls are in the game plan
First things first: Investing is a long-term [3] endeavour, which requires you to create a plan [4] and stick to it.
If you’re getting nervous because the stock market seems high or vulnerable, you should first consider if taking any action is sensible. Does your plan really involve you making market timing decisions, or valuation calls?
If you’re an active investor – who is willing to risk under-performing the market as a consequence – then you may have decided in advance that you’ll reduce your allocation to equities if the market looks expensive or over-extended by some specific metric. Perhaps you’re watching P/E ratios, for example, or 200-day moving averages.
Passive investors, however, should typically ignore all that, and instead drip feed money in over the long-term, rebalance according to age [5] and asset moves [6], and ignore pointless prognostication from stock market pundits.
For you, a volatile stock market is to be welcomed. It increase your returns [7].
If you’ve set up a passive plan and you’re worried, then maybe you’d be better served by a game of tennis, a trip to the cinema, or just generally not looking at your portfolio for a few weeks – or even a few months.
I’m serious! Most people should allocate their money between different asset classes based on factors such as their age, risk tolerance, and their future financial requirements.
Changes after that should be made according to your own pre-determined rules, not rumblings in your stomach.
For example:
- A good reason to sell some of your equities would be that your holding has risen 50%, and now exceeds your pre-determind allocation band. You’re looking to reallocate some of that money into bonds, which locks in your gains, reduces volatility, and brings you back to your original asset allocation.
- A bad reason to sell is because you saw Robert Peston or Jim Cramer on the TV last night, frothing about an economic slowdown. Or because you fear the Russians are coming.
Turning from a passive grin-and-bear-it investor into an active trader just because the market is falling will probably prove a losing strategy.
You get none of the benefits of either approach to investing. You’re arguably even worse than a chump who dives in and out of the markets based on gossip in the pub – because you’re a well-informed chump who should know better.
Ways to reduce risk before a market fall
All that said, if you’re a newish investor [8] and you discover you’re more risk averse than you thought, that is nothing to be ashamed about.
Investing shouldn’t be about emotions, but it definitely involves learning to handle them – and also learning more about yourself as you go.
You get a gold star if you have this revelation after making strong gains – as opposed to getting the fear too late, and deciding ‘to thine own self be true’ once the stock market has dropped 25%!
(In that case, I’d consider trying to be true to somebody else for a couple of years and taking action only after the recovery, rather than selling out at the lows).
Whatever your motivation, if the market feels over-extended and you want to take action, here are some better alternatives to buying short ETFs.
Rethink your asset allocation
Perhaps you’re more nervous about the ups and downs of equities than you anticipated. Maybe you’ve realised a few years of falling stock markets would really ruin your day.
Revisit some model portfolio ideas [9], and adjust your positions to something less risky, at the cost of less rewarding. Typically this will involve holding much more fixed interest (bonds) and allocating less of your money to equities.
Hold more cash
Don’t dismiss holding more cash [10] to dampen down volatility in your portfolio. Private investors in the UK can get comparatively decent interest rates on cash (certainly compared to government bonds) and while cash clearly doesn’t rise in value like bonds when the stock market drops, it obviously doesn’t fall, either.
It’s also easy to deploy your cash reserves into a falling market, meaning your cash pile can do double-duty as a plunge protection fund [11].
Sell down your positions
A professional trader once told me that the best way to reduce risk is simply to turn your positions into cash. To sell, in other words.
There’s no feeling quite as nice as “going liquid [12]” when you trade shares. No messing about with options or short ETFs or a pairs-trade.1 [13] Just sell until you feel comfortable again.
Remember Capital Gains Tax [14]. You may be best selling up in ISAs or SIPPS first, depending on your circumstances, since these are exempt from taxes on gains.
Open an offsetting spreadbet or contract for difference (CFD)
This is closer to what semi-active investors are looking for when they stumble across the short ETFs that don’t actually fit their needs.
Here you bet against the index (or a basket of shares) with a carefully-sized spreadbet so that if markets do fall and take your holdings with them, at least you’ll make something back on the spread bet.
You’re basically hedging your portfolio [15] like a long/short hedge fund would.
The advantage is that you’re gaining some downside protection – if the market falls, the value of your bet against it will rise – without having to incur the trading costs of selling your portfolio, nor the potential capital gains.
If you really are a good stock picker, you can even gain if the market goes up, provided your own portfolio rises more than your bet against it.
Remember: This can be very risky. The most you can lose in a traditional share investment is the money you invest, but your losses are unlimited if you short a rising market. Because spreadbetting is tax-free, you can’t offset any losses against capital gains, either.
Read up on sensible spreadbetting [16] before going any further. (A contract for difference is another option, and a whole other post. They are also risky!)
Trade options
Options are the professionals’ way to buy protection. That doesn’t make them a good idea for you or me.
I’ve never traded options. Pricing is non-trivial. Prepare to do plenty of your own research.
Create your own Guaranteed Equity Bond
If you’re very nervous, you might be tempted to invest via an opaque structured product from a bank, instead of putting your money into tracker funds or buying shares.
You might consider creating your own guaranteed equity bond [17] instead.
It’s easy to tweak your DIY GEB [18] to suit your risk appetite, and you’ll know exactly what’s under the hood.
Don’t believe the hype: The reason banks are selling billions of pounds worth of structured products is because they are very profitable for the banks.
It’s not because they’re a good deal for you and me.
Downside risks
All of these alternatives to a short ETF have their own pros and cons, ranging from the potentially substantial frictional costs [19] of trading and taxes, to introducing new types of investing risks [20].
The biggest risk is the one you’ll hear the least about – that you sell off some or all your shares yet they keep rising afterwards, forcing you to buy back in at a higher price or leaving you with a permanently reduced exposure to equities as you vainly wait for the market to come back.
Markets do rise and fall, but in the long-term most Western stock markets have risen [21].
Many people wait too late before buying back into a rising market [2]. Academic research suggests that trying to run you portfolio like a hedge fund [15] is a losing proposition for the majority of private investors.
Even the pro fund managers have lost [22] to the simplest tracker combination in recent times. A passive approach with occasional rebalancing will likely do better for most people in the long run.
If you’re going to meddle though (and I write as a meddler) then I think these methods have a greater role to play in sensible investing than short ETFs [1], which are more like Scooby snacks for day traders.
- This is where you try to offset one share that falls with another that will go up. You might hold an umbrella maker, say, if you are worried about your big position in a sunscreen manufacturer. [↩ [27]]