Should you buy insurance against a stock market crash?

If you have a great deal of fear about your stock market investments I have some good news.  There are several ways you can protect yourself against market declines with “insurance”. The question is should you buy this kind of coverage and if so what is the best method to do so?

How Do You Protect Yourself Against Steep Market Declines?

As I hinted above, you can protect yourself from nasty stock market spills in any number of ways. Of course one option is to keep your money in cash. If you do that, you never have to worry about the market. You may have other problems that are far worse of course, like never being able to retire.  But at least stock market declines won’t keep you up at night.

Other than parking your money in cash, there are two popular alternatives that some investors use to protect themselves against the downside of investing in the stock market.

Shorting Stocks or Buying Short Selling Funds

You can short stocks or buy short funds and potentially make money when the market goes down. You do this by borrowing stocks when the prices are high and selling them immediately. Then, when the stock declines in value you buy the stock on the open market and repay the debt with cheaper shares. Again you can do this yourself or buy a fund that does it for you.

When you sell short you sell high and buy low. You just do it in an unconventional way.  It was tough for me to get my head around short funds when I first heard about them some twenty years ago. Don’t beat yourself up if this concept seems a little wonky to you at first. Just know that you can sell short or buy these short funds that are structured to make you money if the market drops. You can even buy leveraged  short funds that go up 2 %or 3% for every 1% the market declines.  These are considered very risky ventures.  Just sayin’

Use “Put” Options.

Here’s an alternative way to buy stock market insurance, buy puts.  These are options which grant you the right to sell shares at a fixed price withn a fixed period of time.

Let’s say XYZ stock is trading at $100 per share right now.   You think the market is going to tank and take XYZ down with it. As a result of this, you buy a 6 month put option that gives you the right to sell that stock at $100 per share over the next 6 months.

For the moment, let’s say you got this one right. The market goes down and XYZ plummets to $50 per share. Lucky for you this happens within three months of you buying the puts. Once the shares drop you buy them on the market for $50 and exercise your option to sell them at $100. You’re a genius and just made yourself a nice bundle. You’re a regular Don Corleone you are.

Like selling short, you can do this yourself or buy a fund that buys and sells puts for you.

Are you worried about having too much risk in your portfolio?  Why not have a professional review your portfolio? 

Does It Make Sense To Protect Yourself With These Tools?

If you know exactly what’s going to happen in the stock market, it’s fine to use these tools. Oh and by the way, if you really do know, please call me immediately. I could use a good tip.

The problem of course is that you really don’t know. You might think you know – but you can’t possibly predict the future. The market has a tendency to rise, so betting on the market to decline is risky. When you buy options (like puts) you take on even more risk because your right to profit from a declining stock market expires at a fixed time in the future.

In my book, buying this insurance against market declines is a bad business. That’s because it’s impossible to really predict the market with that much certainty and history is against you.  I believe it’s far better to have the right investment strategy and asset allocation and stick with it.  This is also a short-term trading tactic and I believe that long-term thinking is far better.

Does the idea of having insurance against drastic market drops sound good to you?  Have you ever used short selling or puts?  What was your experience?