Protect Your Portfolio!

Does volatility keep you awake into the wee hours? Do you get sweaty palms when the Dow plunges 200 points right before the market closes? Do you like to tell your friends why the stock market is headed for a subprime-induced crash that'll make the dot-com bust look like a tea party? If so, consider some of the following simple strategies for protecting your portfolio. They might just help you sleep easier at night.

1. Consider cash
The simplest way to protect your downside risk is to allocate a larger portion of your portfolio to cash. This also stores dry powder in case the market does plunge. Although investors overallocated to cash risk looking small-f foolish if stock markets surge, a number of smart investors are boosting their cash allocations.

According to The New York Times, Baupost Group's Seth Klarman, regarded as one of the world's savviest investment managers, last year allocated a whopping 49.8% of the group's portfolio to cash, up from 45.8% a year earlier. FPA Capital Fund, run by the legendary Robert Rodriguez, currently has a 40% allocation to cash and cash equivalents, and Fairholme Fund, my personal favorite mutual fund, allocates about 20% to cash. If those heavy-hitters like cash, it might be a good idea to give this patient approach a long, hard look.

2. Puts
Investors can use puts as insurance. Just like a policyholder pays an insurer a premium to transfer risk, an investor can also pay someone else (the put seller) a premium to eliminate a portion of their risk. In a nutshell, a put goes up in value if the underlying security goes down.

Investors nervous about some of their individual holdings can buy puts to guard against downside risk. Some investors also favor buying "market meltdown" insurance by buying deeply out-of-the-money puts on index-tracking ETFs such as the PowerShares QQQ (Nasdaq: QQQQ), SPDRs (AMEX: SPY), or DIAMONDS (AMEX: DIA).

If a very sharp sell-off occurs, or even a "Black Monday" type of event where the Dow Jones falls 20% in a single day, holders of those put options will be very happy they bought stock market "insurance." Remember, puts aren't free. If the meltdown never occurs, then the put buyer, like the insurance policyholder, has effectively surrendered a small portion of upside in exchange for disaster protection.

3. Placeholders
For the purposes of this article, I define placeholders as stocks that have contractually defined payouts. If the stock markets are declining, it usually pays to be in high-quality bonds such as U.S. Treasuries, which carry the full faith and backing of the federal government. Skittish equity investors will get scared and look for a very safe place to put their money -- also known as a flight to quality.

In addition, bonds have contractually defined payouts that tell investors exactly when and how much they'll get paid. As long as the bond issuer doesn't default, investors will get their principal back, with interest.

Some stocks offer similar risk and reward characteristics, such as arbitrage, liquidation scenarios, and special-purpose acquisition vehicles. These types of investments tend to be less correlated to the stock market. Instead, the payoff depends on whether an event (such as a liquidating dividend) occurs as planned or not. Thus, certain special-situations placeholders can offer reasonable downside protection, as well as a satisfactory rate of return.

Flight to quality also occurs in the stock market, and best of all, many of the bluest of the blue chips already trade at very reasonable valuations. For example, Inside Value picks Wal-Mart (NYSE: WMT) and Berkshire Hathaway (NYSE: BRK-B), Income Investor picks Johnson & Johnson (NYSE: JNJ) and US Bancorp (NYSE: USB), and other stalwarts like American Express (NYSE: AXP) are all what I like to consider "inevitables." Their brand strength, outstanding management, and resulting wide economic moats make their future success highly likely.

To recap, you can protect your downside by:

1. Considering cash
2. Purchasing puts
3. Employing placeholders

Of course, not all of the approaches discussed are a fit for all investors. But combining them selectively and patiently can help you to protect your portfolio -- and rest a whole lot easier.

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Fool contributor Emil Lee is an analyst and a disciple of value investing. He doesn't own shares in any of the companies mentioned above. Emil appreciates your comments, concerns, and complaints. The Motley Fool's disclosure policy sleeps like a kitten.