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Investing Lessons of 2008: Use Protection

By Toby Shute - Updated Apr 5, 2017 at 7:52PM

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Three ways to limit your downside in overheated markets.

2008 was a crazy year and nobody knows for sure what 2009 will bring. We’ve spent the past month reflecting on 2008 and making predictions for 2009. Be sure to check out all of our coverage, including more Investing Lessons of 2008.

After the brutal market sell-off of 2008, many of us may never look at investing the same way again. Bank CDs, gold bullion, and even mattresses may be looking like increasingly attractive places to stash your hard-earned cash.

But you know what? Those money management approaches are not going to cut it. A long-term investment program demands equity-like returns. I know inflation is suddenly the least of anyone's concerns, but it will be back -- the Fed will see to that. To satisfactorily compound your wealth over time, you can't cut Mr. Market out of your life.

That's not to say you have to bear the brunt of the fickle fellow's inevitable mood swings. The whole point is to take advantage of the guy, not to be a passive victim. A critical lesson to be drawn from 2008 is to protect your portfolio when Mr. Market dons the lampshade and market valuations get frothy.

I'll step through three approaches here, at least one of which should suit a Fool of any experience level.

Protection plan No. 1: Sit it out
This technique, practiced by value investors like Seth Klarman and Robert Rodriguez, sounds simple enough: When the universe of compelling investment opportunities shrinks, hold more cash. Then again, how many of us actually put it into practice?

To put it another way: How many of you are kicking yourselves today for not having more dry powder to deploy in today's depressed market? I know I am. It's easy to forget the joy of cash before the crash.

Protection plan No. 2: Get shorty
This approach is a bit more advanced, but using shorts to hedge your exposure to overheated markets has gotten much easier. Thanks to products like the UltraShort S&P 500 ProShares (NYSE:SDS) ETF and the UltraShort Dow 30 ProShares (NYSE:DXD) ETF, you can place a buy order for short exposure just as you would any other stock or ETF. Fellow Fool Zoe Van Schyndel provided an excellent overview of these vehicles back in the summer of 2007 -- which was a great time to get hedged!

That was around the time I personally began shorting the iShares Russell 2000 Index (NYSE:IWM), a broad small-cap index fund, to protect my portfolio. But instead of using an ETF, I bought put options and sold call options. Jeff Fischer recently contributed a great piece on using protective put options, and he's also employing various options strategies in the Motley Fool Pro real-money portfolio.

Whether you're using ETFs or options, it's up to you to decide when to impose or remove portfolio hedges. If you'd rather leave those market calls to someone else, you could consider investing alongside David Einhorn at Greenlight Capital Re (NASDAQ:GLRE) or Prem Watsa at Fairfax Financial (NYSE:FFH). Both of these skilled capital allocators have employed long-short strategies to the benefit of shareholders. Of course, this will leave the rest of your portfolio exposed, but it's better than nothing.

Protection plan No. 3: Ol' faithful
If the idea of shorting leaves you queasy -- and you wouldn't be alone there -- there's always the classic approach to avoiding devastating losses: buying with a huge margin of safety.

Come on, don't groan. I know you've heard this one before, but there's a good reason for that. Value investing works, and it's never too late to convert.

For a while there, it wasn't easy to find astonishingly cheap securities. Suddenly, mispricings are rampant. Foolish advisor Philip Durell wrote recently that it's a fantastic time to be a value investor, and I certainly agree. The Inside Value team has recently teed up some terrific bargains for subscribers, including American Express (NYSE:AXP) and UnitedHealth Group (NYSE:UNH). These bellwethers are not merely in the bargain bin, they're arguably in the fabled 50-cent dollar territory.

Unfortunately, the lessons learned here won't serve their most critical purpose until the next bull market runs wild. That could be many years off, and by then our memories may fail us. My best advice would be to begin incorporating the above strategies, particularly the final one, into your investment discipline well in advance of Mr. Market's next manic phase.

Fool contributor Toby Shute doesn't have a position in any company mentioned. UnitedHealth Group is a Stock Advisor selection. UnitedHealth and American Express are also Inside Value choices, and The Motley Fool owns shares of both. The Fool has a level-headed disclosure policy.

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Stocks Mentioned

UnitedHealth Group Incorporated Stock Quote
UnitedHealth Group Incorporated
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