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You Can Protect Your Portfolio

Are recent losses in the stock market keeping you awake at night? Are you wondering what you can do to defend your retirement portfolio? The good news is that there are things you can do to protect your investments from falling prices. But keep in mind that while Wall Street has a slew of products designed to appeal to stock investors who've gotten burned, many of them carry a high price tag.

Catering to loss aversion
Investors hate to lose money. Behavioral studies have shown that the pain you feel from investing losses is much greater than the happiness you feel when your portfolio rises the same amount.

Responding to the demand this behavior creates, investment underwriters offer a number of products, all of which are designed to help investors reduce or eliminate their losses. The particular features differ slightly from product to product, but you'll find the same important characteristics in all of them: Their returns are tied to the stock market, but they limit your losses while still getting at least some return if the worst doesn't happen.

The lower-risk rundown
Even though they accomplish the same purpose, the many products available to investors come from different sources. Equity-indexed annuities, which are insurance products sold through brokers and insurance agents, offer downside protection but also place limits on how much you'll make if the market rebounds sharply.

Principal-protected notes, on the other hand, are often marketed in place of bonds or bank CDs. Offered by underwriters such as Lehman Brothers (NYSE: LEH  ) , JPMorgan Chase (NYSE: JPM  ) , and UBS (NYSE: UBS  ) , they offer exposure to a wide variety of different markets, including currencies, commodities, and stocks. They ensure that you get at least your original investment back, but you'll usually get just a fraction of the market's return in a bull market.

Other hedging strategies involve different trade-offs. Unlike equity-indexed annuities and principal-protected notes, buying put options lets you keep all of the upside potential of your stocks. You can also buy inverse exchange-traded funds, such as Proshares Short Dow 30 (AMEX: DOG  ) , that go up when stocks go down.

The price you pay
The protection these products offer comes with a cost. The most obvious cost shows in their performance. If an annuity or note offers just 85% of the upside in the market, then the protection you're getting costs you 15% of your return if stocks rise. And these vehicles typically measure stock returns over a period of years -- long enough that in most cases, the markets have time to recover from any losses.

But the more important cost of protecting against market losses is that it can mislead you into following the wrong overall investment strategy. For instance, an annuity tied to the Dow Jones Industrials may look like a stock investment to you. But if it caps annual gains to 10%, its overall returns won't look like the Dow's returns. For example, in 2006, such an annuity would have cost you nearly half the return of the Dow, led by components General Motors (NYSE: GM  ) , AT&T (NYSE: T  ) , and Hewlett-Packard (NYSE: HPQ  ) .

Protect your retirement
Short-term protection looks attractive when markets are swooning. But in the long run, the price you pay for products that offer downside protection can have a big impact on your returns. Although taking on risk is always uncomfortable -- especially in bad markets -- it's the best way to earn the long-term returns you need to reach your retirement goals.

To learn more about retirement investing in challenging times, read about:

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