Is there such a thing as the “perfect portfolio?”

Many investors embark on a seemingly never-ending quest for it – a journey that usually has three goals in mind…

  • Income generation
  • Growth potential
  • Safety

In a three-part mini-series over the next few weeks, I’ll address each area, providing tips on how to slot income, growth and safety into your portfolio, so it’s able to handle whatever the stock market and economy throw at it.

[ad#Google Adsense]I’ll tackle the “Income” and “Growth” portions in parts two and three. But first up… safety.

Stop That Loss

When evaluating risk, many people look at a company’s underlying fundamentals. Clearly, this is crucial. But even companies that boast great fundamentals are subject to the market’s vagaries or extraordinary events at any moment. Recall the Vioxx drug scandal that crushed Merck(NYSE: MRK) shares by more than 40% almost overnight. More recently, BP (NYSE: BP) shares got hammered, too. Both companies are fundamentally sound (i.e. in terms of their financials), but shareholders still lost a ton of money on them.

So how do you combat falling share prices?

For most investors, “safety” means one of two things: Either employing pre-determined stop-losses to get you out of losing positions, or having enough cash as a back-up.

The most obvious way to protect yourself from investment losses is by using stop-losses. Making losing picks is unavoidable and you need to have the discipline to cut your losses quickly and efficiently. Stop-losses enable you to do that.

But safety comes in several forms and there are other ways, too…

Divorce Yourself from Losses With Married Puts

Another investment safety precaution is the “married put.”

This is where you buy a put option against the shares of a company that you already own.

The beauty of the trade is that if the underlying shares move lower, the value of the put moves higher. Alternatively, if the share price rises, the put declines.

The married put is best suited for positions that you don’t plan to hold for very long, since it will cost you money for the “insurance.” However, the cost will be significantly less than a 20% or 25% stop-loss in most cases.

And now for a simple, yet radical, way to protect your portfolio…

Don’t Buy Stocks… “LEAP” to Safety Instead

What’s the easiest way to avoid stock market risk?

Buy fewer stocks!

This is another portfolio safety method I use – and the one I prefer above all others. After all, if I can replicate stock returns – and even exceed them – by using a strategy that costs me less money upfront (and therefore has less risk), why tie up a bunch of cash in shares?

The trick lies in long-dated options – or LEAPS.

They give you the right to grab gains from any stock that offers LEAP options – and do so for a fraction of the price it would cost for you to own the shares outright. In my experience, you can buy most two-year at-the-money LEAPS (those with a strike price close to the current share price) for about 20% of what you’d spend on buying the shares outright.

Not only that, the amount you pay for the LEAPS is the most you can lose. And if you also use a 20% stop-loss on the underlying shares as your guide for when to get out of the option, your losses would likely be limited to less than 10%, due to the time and risk premium that would remain in the option’s price.

So next time you fork out $30,000 to buy 1,000 shares of a stock, know that you can achieve the same goal with $3,000 to $5,000 invested in LEAP options instead. For example, if you’d held LEAP options on Merck or BP when their catastrophes hit, you’d have certainly minimized your losses. And aside from extraordinary events, LEAPS give you more safety when assets fall.

Many investors don’t know how to invest properly using LEAPS. But these long-term options should be in your portfolio and should essentially replace companies that aren’t paying you dividends.

So do yourself a favor and see which of your non-income producing share holdings have LEAP options available. Then figure out how much it would cost to substitute each position with a two-year at-the-money LEAP option. The savings – and therefore the safety – will astound you.

Good investing,

— Karim Rahemtulla

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Source:  Investment U