Saturday, November 28, 2009

You buy insurance on your possessions and your life why not your investments?

I’m writing this blog on Black Friday as the world markets came under pressure with the problems in Dubai loan payments. The leaders are saying this is an isolated problem and the amount at risk is no problem for the word markets. We heard that same statement made about the US real estate market two years ago. I don’t know if there is a bigger problem, but I have learned that where there is smoke there is fire. Only time will tell how serious the problem turns out to be.

Just think, if you bought gold on Wednesday you are down $33 in two days. Most of the global stock markets are off 3% to 5%. Here is the question for consideration: Is this the correction the markets have been looking for or is this a dip and in turn a buying opportunity? It is somewhat ironic that we set a 14-month high on the Dow Jones at the close of business on Wednesday and then had this correction. It is possible the Dubai problem becomes the event that takes some of the froth off the market and causes people to rethink the valuations of the market.

The significant amount of volatility in the markets raises questions. How can I protect myself when prices fall on stocks and bonds without selling and going to cash? which is paying nothing). One of the trade offs in making the sell decision is: If I sell a stock that has a current yield of 8% and then invest in a money market fund earning close to zero I’m giving up a significant amount of income.

It is possible, to some degree, to protect yourself on the downside. There are many ways to buy this insurance; some insurance is short-term while others can be left in place for years. For most of my clients I tend to use insurance that has no time limit. One form of short-term insurance is options. Options give you the right to buy or sell your stock for a price for a specific time frame. The problem with this form of insurance is that stock options are for a specific stock and while it may give some insurance on one specific stock it can’t give you protection on an entire portfolio of stocks and no protection on bonds. You can trade futures on both stock and bond markets but again, for the most part, they have a specific time frame.

I want longer-term protection that gives me the longest times frame and covers the broad stock and bond markets. I have found that using Exchanged Traded Funds (ETF) for both the S&P 500 and the bond markets gives me the greatest flexibility. I understand that some people think that these short ETF’s should not be allowed. They believe that people do not understand the risk of these investments. I could say that many people do not understand much of the risk they are taking with their investments.

I use the SDS, ETF for insurance on the downside for the S&P 500 and the SSO ,ETF for the long side of the market. In the case of Treasury bonds I use the TBT, ETF to buy insurance on the short side of the fixed income markets. Let me point out that I’m not trying to time the markets; I know that markets go up and down and they don’t do this in a fixed manner. I may have to hold on to a long or short position for an extended period of time before I sell. Here is the point. If I’m short the market with the purchase of the SDS and the market goes up, then hopefully my stocks will go up and my ETF will fall in value. When the markets turn and stocks fall then my SDS will start to increase in value. Just like insurance on your home you hope you never have a claim but if you do have to file a claim then you feel good about having the protection. The use of long and short ETF’s can give you long-term protection and most importantly reduce the volatility of your investments. Don’t you wish you could buy insurance on the declining value of your home? You can, the symbol is HPB.

Dan Perkins



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