I’m worth more dead than alive.
I don’t mean that to be morbid, and no, don’t worry, I have no fear for my life.
I’m just practical.
I have a wife and three kids who would be financially devastated were I to get hit by a bus.
Assuming I don’t die, the premiums I pay are “wasted” money. But I’m good with that because the consequences of not having insurance outweigh the cost of paying for it.
Likewise, my home is insured … and that ain’t cheap either. I pay a couple thousand dollars per year in homeowners insurance.
I’m a numbers guy, and I weigh the costs and benefits here.
What’s the “real” risk that a tornado rips through my neighborhood or the house burns down? It’s so small as to be infinitesimal … but were it to happen, I would feel like an idiot if I were uninsured.
I also have auto insurance, disability insurance, health insurance … the list goes on.
But this brings up a relevant question: Given the importance of my investment portfolio to my financial future … should I also have portfolio insurance?
My answer might surprise you, but it’s “no.” Let me explain…
What Is Portfolio Insurance?
Insuring a stock portfolio is easy enough.
If you want to protect against the risk that your Microsoft shares decline in value, you can buy put options on Microsoft Corp. (Nasdaq: MSFT) stock. If you want to hedge against a broader market decline, you can buy put options on the S&P 500 Index or on the SPDR S&P 500 ETF Trust (NYSE: SPY).
Just as when buying a life insurance policy, there’s a host of decisions you need to make:
- What is the term of the insurance? When talking about options, the expiration date fills this role.
- What is the deductible? By that I mean, how deep out of the money are the options?
But overall, it’s an easy enough process that an investor with some experience can execute.
Just because you can do it doesn’t mean you should.
And here’s why.
Put options tend to be systematically overpriced.
Here’s an example.
Let’s say you own Microsoft and want to protect yourself against a nasty decline over the next year. You could buy MSFT put options with an expiration date of September 15, 2023, and a strike price of $230. Were the price of Microsoft to dip below $230, your insurance would kick in. Let’s say that on the day of expiration, Microsoft is trading at $220. Great! Your insurance just paid you $10 per share.
The problem is the cost. As I write this, those MSFT puts are priced at $23.13. That’s about one-tenth of the value of the shares at current prices.
To put that in context, my homeowners insurance costs me something like 0.3% of the value of my home each year. That’s a small price to pay for security.
That’s some crappy insurance.
I want to be clear that buying puts can be great as a speculative trade.
My friend (and our chief investment strategist here at Money and Markets) Adam O’Dell helps his Max Profit Alert readers use puts to play the downside of the market.
No surprise that this year … they’ve been making out like bandits on a lot of those trades: more than 100% shorting European stocks … 181% shorting Spanish stocks … and 214% shorting U.S. small-cap stocks … all by buying puts on ETFs.
Adam knows how to buy put options because he knows how to spot which ones are trading for less than they’re actually worth.
But as I said, as general portfolio insurance, puts are too expensive to be worth it in most cases. There are better and cheaper forms of risk management out there.
My Go-Tos for Risk Management
This isn’t an exhaustive list, but here are the techniques I lean into.
Every investor is a little different here, but my general rule is that no stock should make up more than 3% to 5% of my portfolio, and speculative positions should be even less.
Yes, you have to take risk in order to earn a return in the market. But you don’t have to be a cowboy about it.
My rule on where to set the stop is a longer story for another day, but I can summarize like this:
- Smaller, more volatile positions come with wider stops. I don’t want to accidently get stopped out of a position due to a swingy day of trading.
- Larger, less volatile positions have tighter stops. I can almost plan for these as I see a stock trending lower.
The key is just to define how much risk you’re going to take before getting into the trade.
Bottom line: Remember, your portfolio is NOT your house.
If your house caught on fire, you couldn’t sell it while it was burning down.
That’s why you need insurance.
But your stock portfolio is liquid. If you’re watching it, you can trade out of dangerous situations. Insurance is less critical in that case.
And while I think options are lousy as insurance, I love them as a trading tool.
If you want to add options to your trading arsenal, Adam is a top-notch guide. He busts the myth that these trades are only for the Wall Street elite and shows you how everyday traders like you can take advantage.
To find out more about how he’s turning the market’s maximum pessimism into maximum profits using options trades, click here.
To safe profits,
Charles Sizemore, Co-Editor, Green Zone Fortunes
Charles Sizemore is the co-editor of Green Zone Fortunes and specializes in income and retirement topics. He is also a frequent guest on CNBC, Bloomberg and Fox Business.