De-risking your portfolio in a bear market (Part-I)

With the market having sold off by 50% over the last year, long-term investors now face a dilemma of sorts.

On the one hand is the view that valuations are now attractive and this is a great time to pile into the stocks of some of those companies you have been tracking for sometime now. On the other hand is the fear of a prolonged recession and markets remaining depressed (or worse, falling to new lows). Eitherways, you risk feeling like an idiot – “Damn, It was the buying opportunity of a lifetime and I missed out. My portfolio would have doubled in value if I had taken the plunge.” OR “What was I thinking? The whole world, from top hedge fund managers to the shoe-shine boy knew this crisis was getting worse”. At FourStocks, these are the issues we think about...all the time. And here we discuss how, as a serious investor, you can 'de-risk' your portfolio.

The biggest risk during a downturn is the risk of a broad market sell-off in spite of your stocks/companies performing better than their peer group or industry. Despite your good selection of stocks, you could still make a loss on your overall investment. For example, look at companies like BHARTI AIRTEL, L&T, INFOSYS and ONMOBILE. In spite of significantly outperforming their peers and decent income growth yoy, their stock price could not avoid a beating since Jan 2008.

So, what we need to do is remove the 'market risk' from your portfolio and retain only the 'outperformance' of your portfolio over the market. The tools to do this are using derivatives - futures or options. In this 3-part series, we discuss how to hedge portfolios with derivatives. In this article we will discuss the basics of portfolio hedging with futures. The next article will cover portfolio hedging with options and the final article will elaborate on issues like roll-over, rebalancing, taxation, brokerage and on bringing it all together.

Click here to read the first article of the series.