[The following question and answer were written shortly before the recent market drop.]
“I know they don’t ring a bell when the market hits the top, but a fish company doubling because they whisper the word ‘internet’ does reverberate somewhat. How would you suggest an ordinary investor protect against a big market collapse? I would like to hedge against a drop without risking all or most of any potential continuing rise (in case there are more ‘greater fools’ out there.) I’m sure there were similar signs as the market struggled to break through the then unheard of DOW 3000 level, and obviously selling would have been a disaster. I have a mix of tax-sheltered and after-tax investments. What I am looking for is a way to turn some of the potential paper losses into real gains in the event of a big drop, yet at a small enough cost such that if it doesn’t happen, I will feel the price was worth the peace of mind. I know this is a tall order, but if anyone has a practical answer, you’re the man.” – Paul Berkowitz
Thanks, Paul. You are looking for the thing EVERYONE wants, and it comes under the category of a free lunch.
You can certainly buy puts or short some stocks or find a hedge fund you think will short stocks better than you could … but the simplest solution is often best. In your case, it would be to take some profits in your tax-deferred account.
If the market just keeps going up, you’ll be pleased – and may not hate me for getting just 5% or 6% on half the money in your tax-free account (in shortish-term bonds and sensibly-chosen REITs, say). After all, you’ll be getting rich in your taxable account and part of your deferred account.
If the market plunges, you’ll be glad you took some profits.
In assessing the mix between stocks and cash (or other pretty safe stuff), each person needs to find his own sleeping point. That is not the point, I should note, at which people blissfully ignorant of the risks sleep well but rather the point at which you, who do understand them, sleep well.
To buy enough puts to accomplish the same sweet sleep is very expensive (and shorts are no way, really, to get any sleep at all, witness my piranha-infested swim down the Amazon.com). What’s more, any gains, by and large, will be fully taxable.
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