5 Ways to Protect Your Portfolio From a Correction

It's been nearly six months since the S&P 500 began its precipitous rise, and we have yet to even endure a 5% correction in that time. It might seem as if I'm regularly jumping on the bearish bandwagon, crying "wolf" when nothing seems wrong. But the stock market won't rise forever, and a correction looks inevitable. Therefore, it pays to think ahead. Consider putting a few strategies in motion to protect your portfolio when a market downturn does occur.

Below, I've outlined five approaches that might help you weather the storm. Not every situation works for every individual, but chances are good that at least one of these strategies may make sense to you.

1. Consider gold
Uncertainty is a common cause for a stock market drop, and no commodity tends to respond more positively to the resulting flight to safety than gold. Gold represents a tangible investment that doesn't evaporate during recessionary times -- unlike corporate earnings. Unfortunately, finding investing success within the gold sector can be harder than winning at whack-a-mole, since many of these companies are still in the exploration stages of their existence.

One solution is the SPDR Gold Trust (NYSE: GLD  ) . This exchange-traded vehicle holds physical gold, giving you the opportunity to profit from a rally in the underlying commodity without exposing yourself to the potentially fluctuating costs of individual mining companies.

2. Make puts your friend
You might think that the best way to prepare for a market correction would be to sell stocks short. But as even I've learned, the market can stay irrational longer than you can stay solvent. Shorting a stock leaves you exposed to losses greater than your initial investment, yet offers a maximum return of only 100%. Instead, put options could be your best avenue to downside success. Buying put options risks only your initial investment, and gives you a return potential greater than 100%.

Put options can also provide a hedge against current long positions. Netflix (Nasdaq: NFLX  ) comes to mind as a possible put candidate, after its strong rally following better-than-expected earnings. Shareholders could hedge their bets by purchasing puts to offset losses in a general profit-taking pullback. Puts aren't for novice investors, but those who feel comfortable with options may find this strategy very lucrative.

3. Use your easy button
History has proven that you have a greater return potential if you hold for the long term, as opposed to trying to time the market. Having a well-balanced portfolio could make the difference between enduring a portfolio hiccup or a monetary freefall. To help curb those freefalls, consider investing in low-beta consumer staples stocks.

Consumer staples usually have considerably smaller daily fluctuations, and their businesses often remain consistent even during weak economic times. Two companies that fit this description are Procter & Gamble (NYSE: PG  ) and Kraft (NYSE: KFT  ) . Both companies have strong brand names with household appeal, and both have delivered healthy and growing dividends to shareholders. These companies' products find their way off the shelves and into consumers' homes regardless of market conditions.

4. Follow the money
Although I'd never advocate herd mentality, it does pay to keep an eye on what the most prominent investors are buying. Big investors Warren Buffett, George Soros, and Carl Icahn didn't become billionaires overnight. Time after time, their impeccable ability to analyze businesses has often allowed them to spot trends before many other investors do.

Carl Icahn, for example, recently reported taking a 9% stake in Clorox (NYSE: CLX  ) , citing what he believed was an undervalued business. Icahn is known for his active role as a venture capitalist; he's made a habit of buying into troubled or stagnant companies that need potentially rigorous changes to turn them around. Clorox's business has struggled under the weight of weakened consumer spending, but its dividend remains healthy. Perhaps Carl Icahn believes that Clorox's brands can be reinvigorated, or possibly pieced out to a potential bidder. Either way, big money is flowing into Clorox, and investors should take notice.

5. Be patient
Finally, we come to what may be the most important thing you can do when preparing for a correction: Don't panic when one actually does occur. Your financial hopes and dreams almost certainly won't come crashing down, just because the indexes moved down 10%. Using sound judgment is paramount to your success as an investor.

To reduce your downside exposure, consider using trailing stops. These allow you to determine the level at which your stock will automatically be sold if it begins to head lower. Likewise, in a rising market environment like we're in now, don't be afraid to use limit buy orders, which are well below current prices.

Right now, I have my eye on Alliance Fiber Optic (Nasdaq: AFOP  ) , which dove after reporting quarterly results that apparently fell short of some expectations. Its forecast appears strong, and strength in the fiber optic sector is unparalleled at present. But even after Alliance's drop, its shares aren't quite cheap enough for me. The level that I feel would make the stock a buy is just a bit lower.

My point? Don't chase a stock higher. Make the values come to you.

Do you have a particular strategy you employ to protect your profits from corrections that I haven't mentioned? Share your thoughts in the comments section below.

Fool contributor Sean Williams does not own shares in any companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong. Netflix is a Motley Fool Stock Advisor pick. Clorox and Procter & Gamble are Motley Fool Income Investor selections. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (5) | Recommend This Article (12)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On February 16, 2011, at 12:02 PM, EnigmaDude wrote:

    Some good advice Sean, although I am surprised to see you recommend gold! What do you think about buying shares of an ultra-short ETF (like TZA or QID) for some downside protection? Not long-term investments obviously, but when that inevitable correction occurs those ETFs could pop.

  • Report this Comment On February 16, 2011, at 2:37 PM, 15foolheard wrote:

    The best way to protect yourself from a correction is not to buy at the top like a "FOOL".

    fool.com asks that we only make respectful posts...however I think it is disrespectful of fool.com to not properly label their news releases in the headline so we know who the poster is. My stomach turns every time I accidentally click on one of your links.

    Please be more respectful of less gullible investors who make their own investment decisions without consulting banal websites such as fool.com, thestreet.com and investors business daily.

    The street and IB BOTH label their headlines so I dont click on their links. Please be respectful of the investment community and do the same.

  • Report this Comment On February 16, 2011, at 6:57 PM, mountain8 wrote:

    Heck, I bought Apple in the $50s on a Fool Recommendation. I bought Netflix averaging about $30 on a Fool recommendation. I bought SIRI at .90 against a Fool recommendation. I could list all my winners and losers and bore your self to tears but the point is, I learn from TMF. I use TMF as a STARTING point in my research. I have several winners and losers that TMF put me on to.

    And I'm made my living as a journalist. I don't see your point.

    I think investors who make their own decisions without referring to some fairly reliable starting point like TMF or the Street or the WSJ or their neighborhood barber are the ones missing opportunities. I refer to TMF and I'm winning (well). If you don't refer to someone or some group for information and opinions, you will die a hubric fate.

    And you're dead wrong. The best way to protect yourself from a correction is to not invest.

  • Report this Comment On February 17, 2011, at 6:48 PM, grinninbrit71 wrote:

    Sure seems like Carl Icahn has invested in a string of companies that wind up in bankruptcy... so is there really a great strategy to protect your money in a downturn? The bulk of his 9 million was the result of an options play which had a tremendous one day gain after filing of purchase of a million shares. He made a ton more money on the options than on the shares and we don't know what he's exercised and taken off the table. Anyway, the point isn't that Clorox like many of his other adventures would head for bankruptcy. Its a much more stable play than many of his flops. But when you crunch some numbers on Clorox verus Colgate verus Kimberly Clark verus ProctorGamble, clorox surely doesn't stand out as any phenomenal value. And now its stagnated and facing input cost pressure like the others, perhaps to an even greater degree. Book value is less than $1 per share. Granted the value is in the consistent cash flow, but really hard to see this as anything very great.

  • Report this Comment On August 08, 2013, at 3:57 PM, jargonific wrote:

    What are your thoughts now on AFOP? It's slowing a bit at 32..

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