3 Ways to Protect Your Portfolio From a Stock Market Sell-Off

Investors have been faced with some volatile market swings recently, and there are risk factors on the horizon raising questions about what comes next. Market sell-offs can be painful and are often cause for added stress in already complicated times, but there are steps you can take to protect yourself and your investment portfolio.

With that in mind, we asked three Motley Fool contributors to profile strategies you can use to fortify your portfolio. Read on to see why they think that taking these steps can save you from a whole lot of financial hurt.

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Move your money away from risk and toward quality

Keith Noonan: Timing market sell-offs and crashes with any degree of meaningful consistency is famously difficult, but there are steps you can take if you think things are about to take a turn for the worse.

Due to the inherent difficulty in predicting when big sell-offs will occur and the potential gains you can miss out on if a crash doesn’t actually occur, many successful investors choose to remain in the stock market even if they think there’s a real possibility tough times could be ahead. They just choose to shift their holdings into sturdier companies that are primed to put up strong sales and earnings performance even if volatility comes calling for equity valuations.

If you’re heavy in tech stocks and get the sense that the market is about to make a sharp turn into bearish territory, that means it could be a good time to move out of speculative growth plays that aren’t yet posting substantial earnings or showing surefire signs of rapid, dependable sales growth. Rather than being heavily invested in that hyped-up company hot off its recent initial public offering, you may be able to significantly reduce your downside exposure by shifting that money to a time-tested category leader like Amazon. Even better, you don’t have to give up the potential for notching significant gains by making such a move.

There’s no perfect formula for ensuring that your portfolio survives and thrives through turmoil impacting the market at large, but prioritizing strong companies is a foundation for success. Re-weighting your investing dollars toward great businesses that are already relatively well established and have qualities that put them in position to rise above the noise is one of the best things you can do if you fear a sell-off is on the horizon.

Own companies you understand

Daniel Foelber: It sounds deceptively simple, but owning businesses that you have a fundamental understanding of can be one of the best ways to protect your portfolio from a stock market sell-off. When your accounts are painted red for an extended period, you may be tempted to stop the bleeding. Selling a good company at a low price is a great way to lose money.

Understanding what you own and why you own it can be a great way to stay levelheaded no matter what the stock market is doing. For example, if a company’s stock price is going down for macroeconomic factors outside of its control, but the investment thesis hasn’t changed, then it’s probably not a good idea to sell. Similarly, if a stock price is skyrocketing despite declining fundamentals, it could be an ideal time to sell.

Warren Buffett put it well in a January 2015 chat with Quicken Loans:

Mr. Market is kind of a drunken psycho. Some days he gets very enthused, some days he gets very depressed. And when he gets really enthused you sell to him, and if he gets depressed, you buy from him. There’s no moral taint attached to that.

What Buffett is saying is that short-term price movements can be completely random. Think meme stock euphoria, or certain cryptocurrencies skyrocketing or plummeting at random. A stock price is merely the reflection of what the market is willing to pay for a security at a given time on a given day. There’s no obligation for you to agree with that price. Therefore, making a game plan before a sell-off and anticipating how you will react if prices fall will give you the tools you need to persevere.

Buy some cheap market-correction insurance

James Brumley: I’ll preface my part by saying this idea isn’t going to be a fit for everyone. But, if you truly believe stocks are due for a steep sell-off sooner or later, a cheap put option on a market index is, well, an option.

An option is the right to buy or sell a particular stock or a particular index at a pre-set price before a firm date. Owning calls gives you the right to buy. In our current scenario though, you’d want to own puts, which grant you a chance to sell at a higher price than those that will be available should the market tank. See, as the market loses value, a put option will actually gain in value.

How much its price appreciates depends on the option in question. The amount of time left until it expires, the price at which your option can be exercised, and the market’s interest that specific put option are all factors that can impact its price. As an example, the SPDR S&P 500 ETF Trust put options that expire on Oct. 8 and that allow you to sell the ETF at a price of $445 will cost you about $950 apiece right now, but they’d be worth around $2,500 per contract if the SPYders are near $420 around that Oct. 8 expiration date. The puts with a strike price of $430 and expiration date of Oct. 1 cost $250 per contract now, but should be worth something close to $1,100 each in the event SPY slides back to $420 by early October.

You could, of course, guess wrong about an impending pullback and see your put options expire worthless, but that’s OK if your only goal was to use them as an insurance policy, so to speak. The irony is, the cheaper this “insurance,” the bigger the prospective gain a put option dishes out in the event of a correction.

If you’re brand new to options, now’s not the time to start learning by risking your real dollars. If you’re familiar with them, though — and approved to trade them — it’s a great way to play defense without selling any holdings you don’t really want to dump yet.

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John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Daniel Foelber has no position in any of the stocks mentioned. James Brumley has no position in any of the stocks mentioned. Keith Noonan has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Amazon. The Motley Fool recommends the following options: long January 2022 $1,920 calls on Amazon and short January 2022 $1,940 calls on Amazon. The Motley Fool has a disclosure policy.

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