Stocks are are record highs, and we are seeing record valuations, record options activity, record optimism, and a record number of new investors entering the market. These are the types of signs you see at a market top, and there is more and more talk of a bubble and possible stock market crash coming soon.
What should you do, if anything, to protect your portfolio?
In this blog post, I am going to share 5 different ways you can protect your investment portfolio against a crash in the stock market.
Before we dive into the strategies, I want to address all of the bubble talk we have been hearing about lately in the news.
Are We in a Bubble?
There are many smart people who disagree about whether we are in a bubble, what the phase of the bubble we are in, or if bubbles even matter anymore.
For example, billionaire investor Ken Fisher of Fisher Investments, admits that valuations are getting frothy, but still thinks we have a ways to go before we start seeing those “animal spirts” you would normally see at a market peak.
Cathie Wood, of the popular ARK Invest, doesn’t see a bubble in the stock market per se, and thinks a bifurcation is happening where the companies that are on the leading edge of innovation will grow into their valuations, while those that aren’t will be left behind.
Raoul Paul of Real Vision recently questioned if “Are We in a Bubble” is even the right question to ask.
My opinion is that we have already past the bubble phase and are in a full-on speculative mania. I plan to write a post about this soon where I will go into detail on why I think this is.
But it is not just me who thinks this, check out the following clips below from legendary investors Jeremy Grantham and Jim Rogers. (Watch the video version of this post below from the 2:40 minute market until 5:45 for the relevant clips).
As you can see we may not have a lot of time, we are talking probably months away – not years away – from the bubble bursting, which is why I want to share these strategies with you before it is too late.
Please keep in mind that this is just a brief overview. Each strategy will be covered in more depth in future articles, as well on my YouTube channel.
The following strategies are listed in order starting from the simplest, most conservative strategy, to the more complex. I think you will want to read all the way through for the last two strategies, which although they might require most knowledge and experience, they can also be the most profitable in the event of a crash.
Strategy #1 – Go to Cash, Wait for the Crash
This first strategy is probably the most obvious, which is simply to reduce your exposure to equities by selling stocks, especially any overvalued or high risk stocks, and holding more cash. Another way of saying this is “Go to cash, and wait for the crash.”
The advantages to this strategy are that it is simple, and you will be prepared to scoop up bargains later when things eventually go on sale.
And this is what the concept of roundabout Austrian investing is all about. The purpose is not to focus on making money now, but to put ourselves in the best position for investment opportunities later.
This may sound like a novel concept when literally everybody seems to be chasing the hottest stock, but I firmly believe there are no shortcuts in investing. We often have to go through short-term pain in order to reap long term gains.
The disadvantages of the cash strategy are that you may miss out some potential upside in the bubble (the short term pain I just alluded to), and if you stay in cash for any length of time you will lose purchasing power by holding fiat currency which is being actively devalued by the central banks.
Strategy #2 – Buy Precious Metals (Gold and Silver)
That leads me to strategy #2, which addresses the problem of inflation eating away at your savings, by using some of that cash to purchase precious metals – namely Gold and Silver.
One of my personal heroes is Ron Paul. In his classic book, The Case for Gold, he calls Gold and Silver real money, and the have been recognized as real money for thousands of years. Those paper dollars that most of us work for, they aren’t real money, and due to inflation, the purchasing power of your dollars are steadily decreasing over time. Gold and silver act as a hedge against the inflation caused by the money printing by the Federal Reserve and other central banks.
There are many ways to get exposure to gold and silver, but what I personally recommend is that you purchase physical gold and silver from a reputable dealer, and keep it in your own possession or with a trusted third party outside of the banking system, such as an insured, private vault.
You may see the Precious Metals resources page for a link to the dealer I recommend and personally do business with.
Strategy #3: Buy Gold and Silver Mining Stocks
Mining companies give you the leverage to the price of gold and silver. Keep in mind this involves more risk than holding the physical metal, and due to the volatility of the price of these stocks, there is definitely a learning curve associated with investing in these stocks.
I have been personally invested in this sector since 2015, and while I have definitely learned some hard lessons during that time, it has also been hugely rewarding.
In addition to doing my own due diligence, I pay for several newsletters by industry experts to help me choose the best mining stocks to invest in. Many of them have both free and paid options to help you find the best mining stocks to invest in.
See the Precious Metals resources page for the mining stock newsletters I recommend.
The last two strategies involve placing some bets against the market, and in the bubble environment we are in, you could say these are the most advanced in terms of execution, which is why I am leaving them for last.
However, if done strategically, these can also be the most powerful in terms of protection, which can allow you to stay invested in stocks and participate in more of the upside of the bubble.
Strategy #4: Tail-hedging with Protective Put Options
An Austrian investor who is famous for tail-hedging is Mark Spitznagel, advisor to Universa Investments and author The Dao of Capital, which is kind of like the Bible for Austrian Investing. I am going to be referring to this book a lot on this website, and I highly recommend reading it. Here is a link to the book on Amazon.
During the “Corona crash” in March of 2020, investors in one of Mark’s funds, which he advises along with Black Swan author Nassim Taleb, had an amazing return of 3,612%.
Keep in mind they have a team of Phd’s and are using some very complex and proprietary derivative strategies that would be impossible to implement for a retail investor, but in his book, he outlines a simpler tail-hedging strategy, which involves spending approximately one half of one percent of your portfolio each month on out of the money put options.
The idea with these put options is that they act as insurance against a crash, and allow you to stay invested in the market even during a bubble phase like we are in now. If the market continues to go up, your put options are rolled over or expire worthless every month, but it is a price worth paying for the crash protection it provides.
The advantages to this method are that you can continue to capture upside in the market, but it does require some knowledge of options and also the discipline to continue purchasing the options every month.
There are also some complicating factors, such as when volatility is elevated the put options become more expensive, and sometimes prohibitively so. I’ve even seen Mark in interviews when asked about retail investors trying to implement this type of tail-hedging strategy, more or less saying “Don’t try this home”.
However, if you take the time to learn to use some basic options calculators, and pay attention to implied volatility and options pricing, I think that some form of this strategy can be adapted to most individual investor’s portfolios.
It should also be noted that a strategy such as this only makes sense when we are in a period of extreme overvaluation like we are right now.
Strategy #5: Shorting Overvalued “Bubble” Stocks
This brings me to strategy #5, and it is not for the faint of heart. This involves taking short positions on some of the extremely overvalued bubble stocks.
While this is not recommended for beginning investors, if you have some experience and are able to manage the risk, it can also be an effective way to guard against and even profit from downside in the market.
Again this can be extremely dangerous as we saw earlier this year with GameStop and AMC what can happen to short sellers if someone decides to squeeze the stock. But in the case of Melvin Capital, who was the hedge fund shorting GameStop, they were also overleveraged and did not appropriately manage their risk.
While short-selling has been getting a really bad wrap in the media, most short-sellers provide a very valuable service to the market. In order to have price discovery in the market, you need to have a two-way street. Short sellers help make markets more efficient and therefore help to allocate capital more efficiently, which is a very important concept in Austrian economics. Short selling also provides incentives to investors to uncover frauds, such as we recently saw with Nikola, and have seen countless time in the past.
As I mentioned before, short selling can be very risky business, but there are multiple strategies that you can employ to reduce your risk by using technical analysis and momentum indicators, and placing stops on your trades.
Please look forward to future blog posts where I will go into more detail on how to time and manage your short sells, as well as further information on all of the above strategies.