Give Thanks for Big Gains (While Also Keeping One Eye on the Door)

All politics aside, so far 2017 has been a very good year for stock market investors. For passive investors using index funds, the major benchmarks have all hit record highs. And for active investors, many stocks have delivered huge returns that normally take years to accumulate. Consider:

  • The Dow Jones Industrial Average has gained 23% over the past twelve months, more than double its average annual return.
  • The tech-heavy NASDAQ Composite Index has done even better than that, up 26%.
  • Even the bloated S&P 500 Index has returned nearly 18%.

On this day of giving thanks, we should all be grateful for so much bounty.

During good times like this, it can be hard to believe that anything could stop the stock market’s momentum. You may look at the value of your rapidly increasing 401(k) plan and wonder if you might be able to retire a little sooner than you thought. It’s only natural to do so, but it can set you up for a big fall if you succumb to the temptation to go all-in on a bull market that is getting long in the tooth.

I’m not rooting for a correction, but at the same time I can’t help but wonder when the current bull market will take a pause. When it does, it could easily backtrack 10 – 20% before finding a bottom. That doesn’t mean you should get out of stocks, but here are three steps you can take to minimize the damage the next time the stock market hits the reset button.

Emphasize Quality over Quantity

There is no denying that the stock market as a whole is highly valued compared to its historical averages.  But there are lots of very good companies that are cheap by comparison. A common way to value stocks is to compare their current share price to their expected earnings over the next year, or FPE (forward price to earnings ratio).

Currently, the FPE for the S&P 500 is about 18 times next year’s estimated profits compared to its 25-year average multiple of 15. However, there are many stocks with an FPE of less than 15, including the most valuable stock in the S&P 500, Apple (AAPL). That does not mean AAPL would not decline in value during a stock market correction. But it probably means it has less to fall than a stock trading at a much higher FPE.

If you have not done so already, I suggest you take a look at the FPE of each of your holdings. That way, you can determine which ones may be most at risk of taking a big hit when the next correction rolls around.

I’m not saying that you have to sell them all now, but you may want to consider limiting your downside risk by placing a stop order beneath them.

Stop the Bleeding

You can place a stop order with your broker to sell you out of a position if it trades at a lower price. If the stock never trades at that lower price then the order is never executed. But if it does then your stop order becomes a market order and you are sold out at the next available price.

Some investors don’t like using stop orders because they fear the stock will turn around and go back up right after the stop order is executed. That’s a possibility, but it must be weighed against the risk that the stock may continue falling even lower if an overall stock market correction is occurring at the same time.

If you have never used stop orders before, you should first do some research to figure out exactly where to place them.

Some investors randomly pick an amount of loss they are willing to tolerate, usually 15 – 20% below the current stock price. Others look at technical indicators such as support levels and Bollinger Bands to identify how far a stock can drop before collapsing.

Regardless of which way you decide to do it, once your stop orders are in place you can sleep easier at night knowing that you have a safety net beneath your portfolio. It isn’t perfect, but it’s better than having no protection at all.

Put a Floor Beneath It

A purer form of downside protection is to buy a put option on each of your holdings. A put option gives you the right to sell your stock at a specific price by a certain date no matter what its price actually is. Of course, you must pay a premium to the potential buyer of your stock for them to agree to it in the first place, so this strategy comes at a cost.

The benefit of using put options is that you know exactly how much it will cost and the most you can lose the moment you enter into the contract. That’s because a put option can always executed at the strike price, even if the price of the stock has fallen far below that.

If you own a lot of stocks, then you may prefer to buy a put option on the entire S&P 500 index. That’s because it’s likely that a drop in the index will also drive down the value of your portfolio by a similar amount. It’s also cheaper to do it that way since you only pay one set of transaction costs instead of one for every stock you own.

No one way of limiting risk is perfect, but it is still better than doing nothing at all. With so much good news already priced into the stock market, now is not the time to be taking a lot of risk. Be thankful for what you have, but also take steps to make sure you hang on to it.

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