If your equity portfolio is 100% invested in individual stocks or stock mutual funds, you should be aware that it's at risk. First, let me explain why, and then I'll suggest some strategies to mitigate this risk.
Stocks: The bedrock of a portfolio
There's nothing wrong with owning a portfolio that is heavily tilted toward individual stocks or stock mutual funds. Equities have proven themselves as the asset class with the greatest potential for wealth creation over long periods of time. However, in an overheated market, even talented, value-conscious stock pickers are exposed to valuation risk.
In 2008, for example, the S&P 500 lost 38.5% of its value (on a price basis, i.e., before dividends). Would a classic value strategy have protected you from such horrific losses? No. In fact, the S&P 500 Pure Value index significantly underperformed its parent index during that bear market, losing half its value. That's not exceptional: Last year, the market fell 16% from April 23 to July 2. Meanwhile, the S&P 500 Pure Value Index declined 20%. This suggests that investors can't rely on a strategy of buying cheap stocks for protection during a market correction.
What no broker will tell you: The market's overpriced
None of this would matter if there were no reason to anticipate a correction. Unfortunately, with stocks overvalued, there is ample justification to fear a pullback. Yes, investors are being bombarded with the message that stocks are cheap right now, but that just doesn't add up. It might look that way to observers who look only at the market's multiple of 2011 earnings, but that isn't reliable.
If we look at two more stable indicators of long-term value, Tobin's q ratio and the Shiller P/E ratio, which is based on average inflation-adjusted earnings over the prior 10-year period, stocks look markedly expensive right now. The S&P 500 could decline more than 20% to 1,000 tomorrow and it wouldn't be undervalued. How would you expect your portfolio to fare in that scenario?
In that regard, owning the SPDR S&P 500 ETF (NYSE: SPY) looks like a risky proposition right now. When it comes to broad U.S. stock exchange-traded funds, I much prefer the Vanguard Dividend Appreciation ETF (NYSE: VIG), with its tilt toward megacap, high-quality stocks -- a segment that looks better priced than the broad market.
2 strategies to reduce portfolio volatility
Thankfully, there are strategies that can reduce the volatility of your stock portfolio. Lower volatility gives investors the resolve to ride out market corrections and allow their stock picks the time to work out. These are two of those strategies:
Covered calls
Income-producing option strategies reduce portfolio volatility. Take Motley Fool Pro, which has written covered calls on consumer products company Procter & Gamble (NYSE: PG). A covered-call strategy involves selling call options on a stock you own. The options have a strike price above the market price of the stock. If the stock achieves the strike price, you may be forced to sell some of the shares you own at that price. But keep in mind that you can set the strike price at the outset of the trade, so you can choose a price at which you are comfortable selling your shares.
If the stock does not achieve the strike price by expiration, the options expire worthless and you will have pocketed the entire sum you received on selling the options. The option income contributes positively to portfolio returns and dampens the magnitude of dips in a correction. Procter & Gamble is a good candidate for this strategy because it is a very stable business and relatively easy to value. Other stocks that would do the trick nicely: Johnson & Johnson (NYSE: JNJ) or McDonald's (NYSE: MCD)
ETFs
ETFs enable investors to take on -- or hedge -- exposure at the stock sector or asset class level with the same convenience as buying a single stock. As I mentioned above, the broad market looks overvalued, and that is even truer for the small-cap segment, which the Russell 2000 index tracks. In a downturn, these stocks could be particularly vulnerable. As such, I think a short position in the iShares Russell 2000 Index ETF (NYSE: IWM) is an excellent way of hedging stock holdings.
Investors can also use ETFs to make "positive" wagers. For example, Motley Fool Pro began buying the Vanguard Energy ETF (NYSE: VDE) in February 2009, ultimately building a 3% core position with an average cost below $66 per share and an expected holding period of three to five years. In less than two years, the position has generated a 50% return, yet Pro continues to rate this ETF a buy. With oil looking set to breach $100 per barrel, that looks far from unreasonable.
The missing 30%
Motley Fool Pro aims to have 70% of its$1.4 million real-money portfolio in individual stocks and the remaining 30% in stock-related strategies, including ETFs, options, and short positions. That's the 30% I alluded to in the title, the 30% that could protect your stock portfolio during periods of market stress and enhance returns with exposure to specific stock sectors or other asset classes.
Completing your portfolio
If you're interested in finding out more about putting that 30% to work for your portfolio in 2011, simply enter your email address in the box below. In return, Pro advisor Jeff Fischer will send you his free report, 5 Pro Strategies for 2011, along with an individual invitation to join Pro, which has reopened to new members for a short time.
