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3 Ways to Protect Your Portfolio From a Crash

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Last week, Congress came up with a last-minute plan to cut spending and raise the debt ceiling. This past weekend, the credit rating of the United States was downgraded by Standard & Poor's from its vaunted AAA status to AA+, the next-highest level. As a result, the S&P 500 has now fallen well under 1,200 after spending most of July above 1,300.

What's an investor to do during these turbulent times? There are several viable ways to protect one's portfolio from a hard landing in these types of markets, but it's hard to sift through the different methods of strategist after strategist in the media. The way I see it, there are three main methods to position one's portfolio against a potential market crash.

Your portfolio may not need a tune-up, but it's always a good idea to perform a regular portfolio evaluation, perhaps quarterly. That way, you can assess the suitability of each holding for your current investment goals and the current macroeconomic backdrop. It's generally not a great idea to constantly trade in and out of the market, but it's certainly possible that your portfolio is in need of some rebalancing.

Raise cash
The easiest way to protect oneself from a market crash is to raise cash. Even if the stock market were to drop 30% tomorrow, cash would hold its value in the short term. It's painful to hold onto cash over long periods of time, with inflation eating away at its purchasing power, but the times of maximum pain are often the best times to hold cash as a hedge in one's portfolio.

Cash is wonderful to have in case excellent bargains crop up. Just ask Seth Klarman, author of Margin of Safety and widely considered one of the world's brightest investors. Klarman's Baupost Group has held as much as 40% to 50% in cash at times, showing a willingness to sit on cash if opportunities are missing.

There's no right way to raise cash, but my preferred method is to sell off whatever stocks are most overvalued. Another way to do this is to take a fresh look at one's portfolio and decide which stocks would be least attractive for purchase given today's market prices. Maybe a stock isn't the most overvalued holding, but an investment thesis is no longer as compelling because industry conditions have changed.

Rotate out of cyclical companies
Another way to protect a portfolio is to rotate out of cyclical stocks. Companies such as Ford (NYSE: F  ) , Caterpillar (NYSE: CAT  ) , and U.S. Steel (NYSE: X  ) have enjoyed stellar rallies over the past few years (though they've fallen recently), but these are also the types of companies that fall the fastest in times of trouble. An investor overly exposed to cyclical companies might consider selling some of these holdings and using the proceeds to buy into more defensive stocks.

Defensive companies can be found readily in utilities, health care, and consumer staples such as food, beverages, and household products. One such basket might include electric utility Southern Company (NYSE: SO  ) , diversified health-care giant Johnson & Johnson (NYSE: JNJ  ) , and leading beverage maker Coca-Cola (NYSE: KO  ) .

The trait these defensive companies have in common is that there's very stable demand for their goods even during times of economic turmoil. Because of these smooth revenue streams, they often pay steady dividends that increase over time. I like seeing capital appreciation in my portfolio as much as anybody, but nothing beats quarterly cash dividends that I can reinvest however I desire.

Add short exposure
Lastly, investors feeling especially adventurous can add short exposure via ETFs such as ProShares Short S&P 500 ETF (NYSE: SH  ) or even short individual stocks. Shorting, or betting that stock prices will go down, is inherently more risky than betting that stocks will go up. While long positions face maximum losses of 100% (limited to cash invested), shorts can face losses well in excess of 100%.

Even so, it can sometimes make sense to have a couple of names or an index that actually goes up in value when everything else is getting crushed. There's something calming about seeing green in what is otherwise a bloodbath.

I recommend investors try raising cash or rotating from cyclical to more defensive companies first; shorts in small amounts can provide welcome hedges that smooth out returns for the investor. If adding a few hedges will allow you to stay the course in tough times, that's a winning outcome.

Foolish bottom line
The important thing to remember here is that investors should constantly reevaluate their holdings so that they are not blindsided by company-specific or macroeconomic events. By selectively playing offense and defense at the right times, investors can make sure they're always positioned properly.

Paul Chi has no positions in any of the companies mentioned in this article. The Motley Fool owns shares of Johnson & Johnson, Ford Motor, ProShares Short S&P500, and Coca-Cola. Motley Fool newsletter services have recommended buying shares of Coca-Cola, Ford Motor, Southern Company, and Johnson & Johnson. Motley Fool newsletter services have recommended creating a diagonal call position in Johnson & Johnson. 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.

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