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The stock market is once again at lofty levels, with the Dow Jones Industrials (DJINDICES: ^DJI ) setting a new all-time record high yesterday. Many investors are starting to look seriously at increasing their stock allocations for the first time since before the financial crisis. Yet an increasing number of investors believe that the end of the four-year-long bull market is at hand, and they're sending huge amounts of money into specialized volatility-tracking products that should rise if the market crashes. To protect your hard-earned profits from a future downturn, should you follow their lead?
Later in this article, you'll learn about three strategies you can use to reduce your losses in the event of a future market crash. First, though, let's take a closer look at the increasingly use of popular volatility ETFs and why their high-risk characteristics aren't for everyone.
The big bet on volatility
Exchange-traded funds that track volatility have captured the attention of traders pretty much since their inception. By holding futures contracts based on the S&P Volatility Index (VOLATILITYINDICES: ^VIX ) , these ETFs rise and fall with the daily changes in expectations of how violently the stock market will move over the short run. With the index itself based on options prices, ETF shareholders are essentially taking on the risk of two layers of derivatives within the product.
Yet investors have been fully willing to take on those risks lately. A report in Barron's yesterday said that new investment in leveraged volatility funds ProShares Ultra VIX ST Futures (NYSEMKT: UVXY ) and VelocityShares Daily 2x VIX ST (NASDAQ: TVIX ) has exceeded half a billion dollars since the beginning of the year, while the unleveraged iPath S&P 500 ST VIX Futures (NYSEMKT: VXX ) has received $620 million.
Using these products, however, is an expensive way to protect your portfolio. In the absence of a crisis, the value of these ETFs can erode quickly. So far this year, the unleveraged volatility ETF has lost more than 35% of its value, while the leveraged ETFs are down more than 60%. If you aren't able to time a crash perfectly, then by the time it comes, you might find that you've suffered losses you can't bounce back from.
3 safer ways to protect your profits
If that's more risk than you want, there are alternatives to investing in volatility ETFs that can match up more closely to your goals and risk tolerance. They don't involve sophisticated products but rather incorporate simple financial planning techniques.
1. Rebalance your portfolio.
If you haven't made any changes to your investment portfolio over the past four years, then you probably have a much higher allocation to the stock markets than you might expect. With stocks having more than doubled in four years, their higher value leaves you at greater risk of big-dollar losses in a downturn.
By rebalancing, you'll scale back your stock exposure to more risk-appropriate levels, selling high and locking in a portion of your profits. Rebalancing regularly is usually a good idea, but it's especially important after a big run-up or decline in order to keep your investment balance where it should be.
2. Look at lower-volatility stocks.
Some stocks are more prone to big jumps and drops in fast-moving markets than others. Especially among high-growth businesses trading at sky-high multiples, any whiff of trouble ahead can bring share prices plunging.
By contrast, defensively oriented businesses aren't nearly as vulnerable to the ups and downs of the economy and therefore have more stable share prices. One caveat: Many stock favorites with these characteristics have seen their valuations rise substantially, so make sure you don't overpay for stalwart stocks or else you could be taking on more risk than you expect.
The value of diversification came into question during the financial crisis, when just about everything plunged in value at the same time. But historically, different types of investments haven't all traded in lockstep, and having more variety in your portfolio can help you avoid company- or sector-specific events that could otherwise crush your net worth.
Mixing stocks of different sizes, geographical locations, and growth and value characteristics will give you the most protection from anything short of a full-blown market collapse. Adding investments beyond stocks can go even further, especially if returns on those investments aren't highly correlated with the stock market.
The time to think about protecting your gains isn't after the market has already dropped; it's now, with healthy markets at record highs. Taking these simple steps won't make you rich, but they'll help you preserve what you've worked so hard to earn.
To learn more about a few ETFs that do have great promise for delivering profits to shareholders in a recovering global economy, check out The Motley Fool's special free report "3 ETFs Set to Soar During the Recovery." Just click here to access it now.
Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance. You can follow him on Twitter @DanCaplinger.