3 Smart Ways to Protect Your Stock-Market Gains

If you’ve owned stocks, especially U.S. stocks, since the bull market began in March 2009, give yourself a pat on the back. In little more than six years, Standard & Poor’s 500-stock index has produced an annualized total return of nearly 23%. A $10,000 investment at the start of the bull market in a fund that tracks the S&P 500 is worth about $35,000 today. Thanks to those remarkable returns, you may be daydreaming about retiring a bit sooner than you might have thought possible during the darkest days of the financial crisis—or being a touch more comfortable when you do. The only catch: To make those dreams a reality, you must hang onto your gains. And that’s not easy to do.

Most investors have learned—sometimes the hard way—that what goes way up can also go way down. And although the pre-conditions for a new bear market don’t seem to be in place, stocks are certainly not cheap, with the S&P 500 trading at about 18 times estimated 2015 earnings. A dip in the economy or a jump in interest rates could smack stock values back to earth. “When we see the market at all-time highs, we don’t automatically think, ‘Red alert! There’s a crash coming,’ ” says Mark Brown, managing partner at Brown & Tedstrom, a Denver money management firm. “But it’s unusual to go this long without even a 10% correction, so you should be prepared.” (The stock market’s last correction, defined as a loss of 10% to 20%, occurred in 2011.)

So although the timing of the next setback is uncertain, this might be a good time to protect your hard-won gains. How do you do that? Some ways are better than others. Like buying insurance for your life or property, each comes with a cost. The key is doing enough to protect yourself without doing so much that the cost becomes prohibitive.

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One tactic we’re not keen on is the use of stop-loss orders. A stop-loss order triggers the sale of a stock (or an exchange-traded fund) once the security drops to a price that you designate beforehand. But stop-loss orders can be dangerous in volatile markets, says Brown. That’s because, he says, they can trigger the sale of a stock you want to keep because the market has suffered a temporary drop, as happened during the infamous 2010 “flash crash,” when the market plunged 9% in five minutes before quickly recovering.

Other ideas for mitigating stock market risk seem more appealing. Here are three:

Trim your stock holdings

The simplest way to cut stock market risk is to hold fewer stocks—or, to be more precise, to reduce the percentage of your portfolio devoted to stocks. We’re not suggesting that you sell all of your stocks in anticipation of a bear market. That’s market timing, and few people can do it consistently well enough to make it worthwhile. But if you have 80% of your portfolio in stocks, you may want to consider cutting the allocation to 70% or 60%. Let your time horizon and tolerance for risk and potential losses dictate the amount of the reduction. The sooner you’ll need to put your money to work and the queasier you’re likely to get at the sight of losses on your brokerage or 401(k) plan statement, the more you should consider cutting.

If you own individual stocks, apply the same analysis you employed when you invested in the companies. Did you buy because you expected the firm to generate rapidly growing profits? If the company is no longer delivering the goods, consider selling. If you bought the stock because it looked cheap, is it still a bargain? If you own funds, consider weeding out those that hold big weightings in technology, biotech and stocks with big cult followings, such as Amazon.com (symbol AMZN) and Netflix (NFLX). Don’t forget that selling can have tax consequences. One simple rule of thumb: Realize capital gains in tax-deferred accounts, and take losses in taxable accounts. You may want to consult your tax adviser before acting.

Wall Street’s euphemism for paring back stock positions is “raising cash.” But cash really is trash today, and although making nothing beats a loss of any magnitude, you can do better with the proceeds of your stock sales than to put them into cash. One possible option is Fidelity Total Bond (FTBFX), a member of the Kiplinger 25. The fund, which yields 2.4%, invests in a mix of corporate and government securities. Its average duration is 5.1 years, intimating that the fund’s share price would drop by 5.1% if interest rates rose by one percentage point (bond prices and rates generally move in the opposite direction). Worried about the risk of higher rates? Consider Fidelity Floating Rate High Income (FFRHX), which invests in bank loans made to companies with below-average credit ratings. The interest rates on those loans typically reset every 30 to 90 days, so the value of the loans should hold steady even if rates rise. The fund yields 4.0%

Diversify your stocks widely

Because U.S. stocks have left nearly all other investments in the dust over the past few years, they could well dominate your portfolio. This is an especially good time to make sure you have adequate exposure to foreign stocks, which as a group are cheaper than U.S. stocks and recently have begun to perk up. “Everybody wants to own the S&P 500,” says Steve Janachowski, chief executive of Brouwer & Janachowski, a San Francisco money manager. “But the U.S. market is arguably the most overvalued stock market in the world. If you don’t diversify, you’re taking a big risk.”

Because U.S. stocks have performed so well, investors who haven’t rebalanced their portfolios in the past few years are likely to have a disproportionate share of their assets in big U.S. companies. Now is the time to sell some of those holdings and buy assets that have been lagging. This classic rebalancing move reduces the risk of having too much money in an overvalued investment category.

What if we have a repeat of the financial crisis, during which almost every stock category imploded? If that happens, diversification won’t help much. But chances are good that the 2007-09 bear market was a once-in-a-generation or maybe even a once-in-a-lifetime event. Most of the time, different kinds of stocks—including large-company U.S. stocks, small stocks, foreign stocks, real estate investment trusts and high-dividend shares—perform differently enough to justify holding a little bit of all of them in your portfolio and ensuring that not everything you own will retreat at the same rate at the same time the next time a bear market arrives.

Hedge your bets

Trading options can be risky. Options give you the right to buy or sell a security within a given time and allow you to put up a small amount of money to control a lot of an asset. If your bet is right, the payoff can be great. If it’s wrong, you can lose your entire stake.

If you’re nervous about stocks, but tax or legal issues (such as having assets tied up in a divorce) make it impractical to sell, buying a “put” option on a market index is a reasonable strategy. A put gives you the right—but not the obligation—to sell an index at a fixed price by a certain date.

Say you have $100,000 in U.S. stocks and worry that a bear market (a decline of at least 20%) could materialize by the end of the year. You could buy puts on SPDR S&P 500 ETF (SPY), an exchange-traded fund that tracks the S&P 500 index. With the ETF trading at $211 on April 24, 500 shares are worth a bit more than $100,000 ($105,500, to be more precise). Each put contract covers 100 shares of the underlying investment, so you could hedge your entire stake (and then some) by, for example, buying five contracts that allow you to sell the ETF for $210 per share by December 31. If the ETF were to fall 20%, to $168, your five put contracts would be worth $21,000 (the difference between the $210 price at which you could sell the ETF and the $168 market price, multiplied by the 500 shares controlled by the five contracts), says Marty Kearney, senior instructor with the Options Institute at the Chicago Board Options Exchange.

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The downside is that puts, particularly those that provide protection for many months, are not cheap. In this case, each contract would set you back $1,154 at April 23 prices, for a total cost of $5,770—nearly 6% of the nest egg you’re trying to protect. And if the ETF closed at $211 or higher on December 31, the option contracts would expire worthless. When you buy this type of put option, you can’t lose more than its cost, but given the price of protection, you’d only buy this type of insurance if you couldn’t live without it.

A way to hedge without having to worry about being wrong about the time frame is to buy an exchange-traded fund that moves in the opposite direction of the stock market. Examples of these inverse ETFs are ProShares Short S&P 500 (SH), which seeks to move in the opposite direction of the S&P 500; ProShares Short QQQ (PSQ), a bet on a decline in the Nasdaq Composite index; and ProShares Short Dow 30 (DOG), which moves in the opposite direction of the Dow Jones industrial average.

One shortcoming of inverse funds is that they can guarantee to meet their objectives only on a daily basis. That sometimes leads to surprising results. For example, in 2011, when the S&P 500 returned 2.1%, ProShares Short S&P 500 surrendered 7.8%, far more than would have been expected. But the funds have shown their mettle when stocks crater. In 2008, when the S&P 500 plummeted 37.0%, the ProShares ETF soared 38.9%.

And given that the stock market always recovers from bear markets eventually, it’s foolish to hold an inverse fund for the long term. Anyone who has held ProShares Short S&P 500 since the bull market began has learned that lesson the hard way: Since the start of the bull market in 2009, the ETF has lost 77.5% of its value.

Indeed, for money you won’t need for many years, the best protection is patience. Although stocks are volatile over short stretches, they beat all other investment categories over the long haul. If you’ve got a strong stomach and a lot of time before you need your money, a little pruning and some diversification may provide all the protection you need.