The idea of insuring or "hedging" a portfolio against market loss is nothing new. The problem is that there is no free lunch. All methods involve giving up some potential return or paying somebody to take risk for you.
"If the market doesn't crash, you're throwing away a lot of money," said Rick Metzger, a broker at A.G. Edwards & Sons Inc. in St. Petersburg. He says investors who express an interest in hedging usually change their minds when they find out the cost.
Recently, with the Standard & Poor's 500 Index at 1,115, you could buy a one-year option that would pay off if the index value fell below 1,100. The cost was $6,800 for $110,000 of insurance for one year. That's expensive unless you really believe the market is about to crash but you don't want to sell your stocks.
"It's less a monetary decision than a controlling-your-blood-pressure decision," Metzger said. "Most people who buy options lose money."
An alternative to insurance is diversification, which means spreading your money across a variety of investments, hoping they won't all go down at once.
Here are some of the ways investors try to insure themselves against stock market losses:
INDEX OPTIONS: You can buy "put" options on an index, such as the Standard & Poor's 100 Index or 500 Index. If the market falls far enough, gains on your options will at least partly offset losses on your stocks. Chief drawbacks: This is expensive and only works if your portfolio mirrors the chosen index and if the market drops before the options expire. Regular index options are sold with expiration dates in each of the four nearest months. LEAPS, or Long-term Equity AnticiPation Securities, are long-term options going out as far as three years. Profits can be claimed any time before the option expires.
LIFE INSURANCE: A common feature of variable annuities, this insurance promises your heirs will receive at least as much as you originally invested. Some annuities increase the insurance to the current market value each year. Chief drawback: You have to die during a down market to collect.
ZERO COUPON BONDS: You can guarantee your portfolio will be worth a certain amount on a specified date by buying zero coupon bonds, which are U.S. Treasury securities sold at a discount and redeemed at face value. This works best if the date is many years away. Chief drawback: Zero coupon bonds are expensive now because interest rates are so low. If you buy enough to insure your portfolio's current value, you'll be overloaded with bonds, giving up potential stock market gains.
MARKET-INDEXED CDs: Some banks offer CDs with variable rates tied to the return on a stock index, with the guarantee that you will at least get back your original investment at maturity even if the market drops. Chief drawbacks: You don't actually earn a full stock market return if the market goes up. Return may be based on where the market stands on the maturity date without regard to what it has done in the meantime.