Make Sure You Are Investing in “Insurance” for Your Portfolio

I didn’t know it, but I was about to shake hands with the man who would help save my portfolio…

On May 6, 2010, I was standing in the Columbia, Maryland, showroom of hhgregg, the now-defunct electronics and appliance superstore.

I wasn’t looking to buy a new washing machine. I was checking out an investment. You see, hhgregg was in the middle of a large market expansion. The retailer’s hard-charging CEO had invited some investors to tour one of his new showrooms with him and other members of senior management.

I jumped at the chance. This level of access to management was not always easy to attain. Especially for a hedge-fund manager who was short the stock – like I was.

But what I couldn’t have known as I pulled into the hhgregg parking lot… was that I was about to walk into one of the scariest days of my career…

The hhgregg CEO, a guy named Dennis May, met us on the showroom floor and was already in full-on salesman mode.

He showed how shopper-friendly his stores were. He provided invaluable details about hhgregg’s generous credit programs for customers who needed help funding a big purchase. (Yikes!) He even played down the risk from Amazon’s continued push into the electronics and appliance categories.

So I was feeling pretty good about our short position as he directed us to the store’s crown jewel – its huge bank of high-definition televisions. He wanted to show us some of the hottest new units, including ones that could display videos in 3-D… so long as everyone was wearing bulky 3-D glasses with long cords that connected back to the TV.

That’s when I stopped listening. Beyond the 3-D set Dennis was touting, a wall of other big screens were tuned into CNBC. And the headline running across the screens in bold letters read: “Dow DOWN 1,000 Points.”

I was watching the now-infamous Flash Crash.

I’d never seen the market hit an air pocket like that. Who had? That was the second-worst intraday drop in the Dow’s history… almost as bad as the 1,018-point fall that kicked off the Great Recession in 2008. But the Flash Crash had happened more quickly. About 600 points of that fall happened in less than five minutes.

Now, I was supposed to be prepared for an event like this…

And on almost any other day, I would have at least felt better prepared. I spent most days during market hours at my computer with a sophisticated trade-management system at the ready… where I could trade in and out of assets as quickly as I needed to.

But today… while all hell was breaking loose… I was stuck in a shopping center in the middle of suburban Maryland.

I immediately called in to my office. My fears were confirmed: Some of our long investments were getting decimated. A few were down more than 15% in less than 10 minutes – and those were world-class companies.

But… as we walked through the rest of our investments, the damage to the overall portfolio wasn’t nearly as bad as the wreckage being described on CNBC. We were down, but nowhere close to the declines of the broader market. Why?

In short, we were prepared… more prepared than, perhaps, even I appreciated before my visit to hhgregg.

Our fund had taken the sometimes painful, but always necessary step of investing in portfolio protection. This protection – for us, it was mostly short sales on individual securities – did not eliminate all our losses on that huge market drop. But we were much better off than other investors who were “all in” on the long side of the market.

And nearly as important, the protection also allowed me to stay calm in that period of extreme volatility. Knowing I was somewhat safeguarded to the downside, I went into attack mode.

To borrow legendary investor Warren Buffett’s quote, we were “greedy when others were fearful” and increased our holdings in a few of our favorite longs that were deeply “on sale” – only the names where we had the greatest conviction, and only because we had previously invested in portfolio protection.

And almost as quickly as it dropped, the market came roaring back. It did not recover all its gains by market close that day, but it did recover by more than half. And some of the buys we made that afternoon produced healthy gains in just a matter of minutes.

But here’s the thing…

If I’m being honest with myself, the Flash Crash was one of the few days that I was truly happy to have invested in such protection. On most trading days, the large potential losses that such “insurance” would help reduce were discounted in my mind… Such losses could never really happen to my portfolio. Instead, like most investors, I was often frustrated by the drag they created, muting the gains I would otherwise enjoy during a bull market.

That’s why it’s important to remember days like the Flash Crash. Because those days are always around the corner. That’s when insurance serves its purpose – big time.

And that’s exactly why I bring this story up now.

We want to make sure that YOU – yes, YOU – are investing in “insurance” for your portfolio.

This “insurance” may cost you some profits in the short run if the market soars from here. But we guarantee you’ll put it to good use eventually.

“Insurance,” or portfolio protection, takes many forms. It can mean allocating part of your portfolio to hard assets, like gold, silver, or timber. It can mean selling short overvalued stocks… an investment strategy that will make a portion of your portfolio go up in value as prices fall.

It can mean investing “higher up the capital structure” of a company – that is, finding a company you like and investing in its more senior, secured debt rather than its stock.

Or portfolio protection can mean simply investing more of your capital in value-oriented securities rather than in growth-oriented ones. Perhaps these value-oriented stocks pay more income… Or perhaps they trade at a much lower multiple to earnings, replacement value of assets, or book value.

In this sense, these value names have a higher “margin of safety” and therefore should not drop as much as the overall market in a downturn.

Market corrections happen. They’re just part of the process. But as the Flash Crash brought home to me, the best defense is to balance your bullish investments with prudent portfolio protection.

One day, you’ll be glad you did.

Good investing,

Austin Root

Source: Daily Wealth