From increasing your cash holdings to buying options, we show you how to defend against a correction -- or worse. By David Landis, Contributing Editor December 31, 2010 Feeling queasy? Even after a bit of autumn indigestion, stocks have risen awfully far awfully fast. From the market’s bottom on March 9 through November 6, Standard & Poor’s 500-stock index rocketed 60%. The tech-heavy Nasdaq did even better, climbing 66%.And although we believe that the market will continue to rise in the coming year (see Where to Invest in 2010), there are no certainties when it comes to stocks. As we went to press, the market hadn’t even experienced a correction -- defined as a decline of 10% -- since March. A drop of that magnitude can occur anytime without warning and without any change in the fundamental outlook. And if the economy -- and, more to the point, the earnings picture -- proves worse than we expect, the bear may make an unexpectedly early reappearance. Are you prepared? Here are seven ways to protect your recent gains from a sudden reversal in fortune. We list them in order of increasing complexity. Strategy 1: Raise cash. Boosting your cash holdings is one obvious way to make your portfolio less vulnerable to a market collapse. You could arbitrarily decide to sell, say, 30% of your stock holdings and move the proceeds into cash (money-market funds, Treasury bills and the like). But there’s no need to make such a drastic move. There are other ways to increase cash without incurring unnecessary costs or missing out on opportunities. Advertisement If you’re rebalancing (see strategy 2), sell some of your winners but keep some of the money in cash rather than buy laggards. If you make regular contributions from your paycheck to a 401(k) or other retirement plan, continue to do so, but direct the new contributions to a cash account rather than to stock or bond funds. If you own dividend-paying stocks, take the payouts as cash rather than reinvest them in new shares. The same goes for distributions from stock funds. Strategy 2: Rebalance. If you own a lot of stocks and funds that have notched big gains the past year, chances are you no longer have the mix of assets you once thought was ideal. Now would be a good time to sell some of your gainers and put the money into assets that haven’t done as well. You should rebalance your portfolio in this manner at least once a year -- more often if big market gains or losses leave your portfolio far from your desired mix. Rebalancing forces you to sell high and buy low (or at least to sell outperformers and buy laggards) -- an ideal way to preserve investment gains and set up your portfolio for further success. Advertisement Strategy 3: Buy low-beta stocks and funds. Beta is a term that describes a stock’s tendency to move in tandem with a particular market index, which by definition has a beta of 1. If the index gains 1% during a given period, a high-beta stock would gain more, on average, and a low-beta stock would gain less. High-beta stocks, such as Apple (symbol AAPL), which has a beta of 1.50 relative to the S&P 500, have done particularly well during the recent rally. Low-beta stocks are likely to hold up better if the market heads south. At Yahoo Finance, we screened for stocks with betas of 0.6 or less relative to the S&P 500 and turned up several dividend-paying giants, such as Monsanto (MON), Novartis (NVS) and Procter & Gamble (PG). You can find low-beta funds, too. A screen we ran at Morningstar.com for diversified U.S. stock funds with betas of less than 0.8 turned up, among others, Vanguard Dividend Growth (VDIGX) and Forester Value (FVALX). But if you want to buy a fund because of its low beta, make sure you first check out its holdings in the latest shareholder report or on the fund sponsor’s Web site. A low beta can indicate that a fund is holding a lot of cash or owns many stocks that aren’t in the S&P 500. Strategy 4: Buy a hedged fund. Some low-cost mutual funds have adopted strategies long used by hedge funds, but they don’t charge hedge funds’ exorbitant fees. These mutual funds use a variety of techniques to make themselves less vulnerable to the market’s declines while still capturing at least some of its gains. If done correctly, these techniques, which can include the use of options, futures and short selling, may be carried out with relatively low levels of risk. Among our favorites: Hussman Strategic Growth (HSGFX), a growth-stock fund that uses options and futures to hedge its market exposure during times of uncertainty; Arbitrage Fund (ARBFX), which specializes in buying shares of companies targeted for acquisition by other companies; and TFS Market Neutral (TFSMX), which holds a combination of long and short stock positions designed to neutralize most of the fund’s exposure to the market’s day-to-day movements. Advertisement Strategy 5: Buy an inverse ETF. Preserving gains from each individual stock in a large portfolio can be expensive and time-consuming. A better bet is to buy an inverse exchange-traded fund, which can cushion losses from a broad market downturn. For example, ProShares Short S&P 500 (SH) provides the inverse daily return of the S&P 500. That is, if the S&P loses 1% on a particular day, the ETF will gain 1%. Conversely, if the index rises 1%, the ETF’s shares will fall by the same amount. If you have a stock portfolio worth, say, $100,000 and you buy 100 shares of ProShares short at its early-November price of $55, you will effectively hedge 5.5% of your holdings. This hedge is not perfect, though. It works best if your portfolio consists mostly of the sort of domestic, large-company stocks represented in the index. Inverse ETFs are available for many market and sector indexes, and some will provide a double or triple inverse return (a 2% or 3% gain if the index loses 1%, for example). They’re less risky than shorting an index ETF because you can’t lose more than the amount you’ve invested. But here’s the catch: These ETFs provide the inverse of an index’s daily return. Because of the mathematical complexities of compounding, their returns won’t necessarily be an exact opposite of the index’s returns. For example, ProShares Short S&P 500 fund fell 23% for the year that ended November 6, while the index gained 21%. That divergence often becomes more dramatic with leveraged inverse funds. Inverse ETFs, therefore, are just for short-term hedging. Even then, keep a close eye on them and avoid the leveraged variety. Strategy 6: Go short. Short selling, which can be used to speculate on a security falling in value, can also provide protection for your gains. It’s an especially useful strategy if you’re trying to avoid or delay realizing gains that you would have to share with Uncle Sam. Advertisement Say you own 100 shares of Apple, which closed November 6 at $194. You borrow 100 additional Apple shares from your broker, sell them and stash the proceeds in an interest-bearing account (if your broker will allow it). If your Apple shares fall to $180, you can close out your short position with a $14-per-share gain (your interest earnings can reduce some of the commission costs). The short-selling gain will offset the loss in your “long” holdings of Apple. If Apple shares rise instead of fall, you’ll lose money on the shares you shorted. Strategy 7: Buy puts. A put option gives you the right to sell a stock at a preset price, known as a strike price, within a predetermined period. If your shares fall below the strike price, the value of your put rises to offset the loss. As with selling short, buying a put is a good move if you have a gain but don’t want to sell your shares right away -- for example, if by holding a stock for a few more months you could convert a short-term gain, taxed at your marginal tax rate, into a long-term gain, taxed at favorable capital-gains rates. In the case of Apple, you could get long-term protection for your gains with a put contract that shields you through January 2011 if the stock were to fall below $190. Cost (as of November 6): $29.95 for each Apple share, or $2,995 plus commission, for a 100-share contract. (Prices change rapidly. Look online for more-recent price quotes.) That’s not cheap, but options generally cost more for volatile stocks, such as Apple. There are ways to lower the price: Insure yourself for a shorter period (Apple $190 puts expiring in April 2010 recently cost just $16.60, or $1,660 for a contract covering 100 shares), or absorb more losses by accepting a lower strike price (at a $165 strike price, the January 2011 put costs $18.70 per share). Better yet, put on a collar. This involves selling a call option, which obligates you to give up some potential gains but produces income that effectively reduces the cost of the puts. You can bone up on options strategies at www.cboe.com.