If you often write about expensive stock markets or shares, it’s no surprise that you’d get asked: “How do I protect myself from a crash?” Today’s market is highly polarized, with both expensive and cheap stocks available. However, if the expensive stocks eventually come crashing down, it’s likely that all stocks, to some extent, will be dragged down with them. The further a stock’s price deviates from its intrinsic value, the harder its fall will be. So, the question of how to protect your portfolio against a crash is absolutely valid. The best investors don’t predict—they prepare.
Protection Strategies
One option is to place a stop-loss order under all your stocks (mentally or otherwise). This ensures that your shares are automatically sold if they fall below a certain price. However, this approach comes with its own problem: when do you get back in? What if the drop isn’t over yet, and you’re stopped out again when you make new purchases? This can lead to additional losses and frustration.
In the past, I’ve used options as a hedge. If you want to take action to limit your risk, this still seems like the best choice. For instance, you can hedge by buying put options on specific stocks. This gives you the right to sell those shares at a pre-determined price. Another possibility is buying a put option on a general market index, which lowers your market risk—even for stocks that don’t have options themselves. Essentially, with these options, you’re buying a form of insurance: you keep your upside potential while knowing your maximum loss in the event of a drop.
Practical Application
Today, buying out-of-the-money puts on something like the QQQ (Nasdaq, where many expensive U.S. stocks are listed) is a valid strategy. I’ve applied this approach myself, though on a limited scale. The reason is that my income—apart from this newsletter—is entirely dependent on my investments. In a crash, I’d like to have some cash on hand to live on, so I don’t have to sell shares at a low price.
The downside of this strategy is its cost. The insurance premium for buying and rolling over options puts extra pressure on your returns. If, like in my case, you’re investing in European stocks that have already underperformed in recent years, that extra cost is far from ideal.
If my income weren’t so dependent on the stock market and I had enough resources to buy cheaper stocks during a crash, I probably wouldn’t buy options. While it remains a valid strategy, I’ve been out of the options world for too long , that’s why I rely on the expertise of others in this area.
A More Natural Approach
In the past, I rarely worried about potential downturns or crashes. My portfolio was naturally more defensive when I found stocks to be cheap and had more cash when stocks seemed expensive. In other words, I was always ready to seize opportunities.
As Peter Lynch once said:
“Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in the corrections themselves.”
Today, the situation is different. In Europe, there have been interesting bargains for quite some time, which has led me to invest a larger percentage of my portfolio than during previous periods of high valuations. I’m not worried about this because I expect our stocks to fall less sharply in the event of a crash—they’re already cheap. Of course, what’s cheap can always get cheaper.
I also ask myself: if I’m not willing to hold onto my shares during a 20% drop, should I even have them in my portfolio today? In my view, such drops—when nothing fundamental about the businesses changes—are buying opportunities.
Focus on Fundamentals
In my opinion, the best insurance remains your own knowledge and thorough research into the companies you invest in. There are three reasons I sell a stock:
It’s become too expensive.
I need cash for a company with more potential.
Something fundamental has changed (or I missed or misjudged something about the company or its market).
All of these reasons are focused on the company itself, not the broader market. If the market drops but my analysis of the companies holds true, it might be unpleasant to look at my portfolio, but it also presents opportunities to buy cheaper shares.
Articles and updates this week
We’re off to a new earnings season! This week, we’ve already received a few brief trading updates, which you can find under the Short News section. Additionally, we took a closer look at the newsletter on Sofina. You can read the full update here: Sofina – My Exposure to AI.
This past Tuesday, I launched an introductory series on value investing, starting with the first lesson: Why Invest. For loyal readers who have been following for a while, this first lesson may feel a bit basic. However, it could still be useful as a refresher or as a resource to share with new investors. In the following lessons, we’ll dive deeper into the content and explore more advanced topics.
The value investing series will alternate with the previously announced series on European stocks. I’ve chosen not to stick to a rigid schedule, so I can take the necessary time to thoroughly research companies when needed.
My priority lies first and foremost with investing – and only after that with writing. In my opinion, this is an advantage for you as well.