Use derivatives as one of the tools to ensure a crash-proof investment portfolio

When Radhika created her mid-cap portfolio in 2017, she had decided that she would automatically rebalance it when the Nifty crossed the P/E threshold of 27X. However, she was in for a surprise when mid-caps crashed by nearly 20% in 2018 and her portfolio was down by almost 35% within a year of its creation.

Where exactly did she go wrong? She had taken a very generic approach to a very specific and concentrated portfolio. That brings us to a larger question; is it possible to ensure that a market crash does not crash your portfolio.

Here is a six- point model:

Build your portfolio around goals

Your portfolio cannot be an exercise in isolation but must be linked to your long-term and short-term goals. If you have a long-term goal that stretches to about 15-20 years; such as retirement or your child's education, then you can use a diversified portfolio of equities or equity funds. In that case, you need not be overly worried about the vagaries of the market. There is one more catch in this argument. What happens if the portfolio loses value around your goal post? For example, if you need to cash a part of your portfolio in the 10th year and that year turns out to be a bad one? The answer is to start shifting to liquid assets at least one year before your actual goal post date.

Try to diversify your portfolio at all times

Diversification has multiple implications for an investor. For example, you need to diversify your portfolio across sectors; too much of steel or banking is not a good idea. Secondly, you need to diversify your portfolio across themes; banking, non-banking finance companies, realty and autos are all rate sensitive. Thirdly, ensure that the stocks in your portfolio have low correlation. If you have a portfolio of stocks that are from different sectors and themes but correlations are high, then there is no way you are going to achieve diversification.

Rebalance your portfolio with changing macro conditions

Most long-term investors are averse to making continuous changes to the portfolio. They fear that it could pose a major challenge to the longevity of the portfolio. But rebalancing here refers to something else. We are referring to rule-based rebalancing. For example, you can set P/E ranges of 12X on the downside and 27X on the upside. Closer to the lower range, you gradually start increasing your exposure to equities and reducing equities closer to the upper range. You can also set a similar range for interest rates. Reduce your government securities portfolio at lower yields and increase it at higher yields. This rule based system can go a long way.

Split your portfolio into core and satellite

The core portfolio is the portfolio that is linked to your long-term goals. To the extent possible, avoid tampering with this portfolio unless there is a strong justification for the same. The satellite portfolio is the portfolio where you seek opportunities. What is the point of being in equity markets if you don't tap the opportunities? There are times when the growth could be slowing or when a weaker rupee could be making IT and pharma attractive. NBFCs may be disrupting the market in a big way or public sector banks may be coming out of a long non-performing asset slumber. These are opportunities you must tap and make profits so that you create a contingency fund within your portfolio for a rainy day.

Adopt a phased approach to investing

A phased approach is like doing a Systematic Investment Plan. You don't put all your money in one go or pull out all your money in one go. This is very true if markets are volatile. Quite often, we buy or sell a stock and then regret having done it too early. Never be in a hurry to buy or sell a stock and try to take a phased approach. The longer you spread your money across the right stocks at the right opportunities, the lower will be your cost and the lesser will be your vulnerability to market crashes.

Don't ignore futures and options

Ever since Warren Buffett referred to futures and options as "Weapons of Mass Destruction", investors have been wary of them. What Buffett was referring to was the use of derivatives for leveraged speculation. You can use these to protect your portfolio. For example, if you are long on a particular stock and it is up by 50% in the last one year, you can sell futures when you sense uncertainty in the market. On the one hand you have locked in your profits but if the market does crash then you can book profits on the futures and reduce the cost of your stock holding. Similarly, one can also use put options and the premium is a small cost to protect against a crash. Use these sparingly, but use them to good effect.

The best way to handle a market crash is to prepare for it. A mix of planning and strategy can go a long way.

The writer is chief sales officer, Angel Broking. The above opinion is for reference only