Protective assets will remain central to diversified portfolios

Put options – effective when properly calibrated
The simplest, most straightforward way of shielding a portfolio is to buy insurance in the form of put options, protecting against downside risk on share prices. The investor must of course pay a premium, but exposure to the underlying stocks is maintained. As with an insurance policy, if a mishap occurs – in this case an equity bear market, the portfolio has at least partial protection for the coverage period. If everything goes to plan, the premium is forfeited, but the portfolio can still gain from the appreciation in share prices.

Such a solution can be costly, as the price of the premium varies according to the duration of the protection, the strike, i.e. the level at which the option can be exercised, and volatility, which tracks how risk-hungry investors are at a given time. Just as it is too late to buy an umbrella in the middle of a storm, it is advisable to buy protection when the weather is fair, i.e. when volatility is low, to keep the costs down. In this instance, however, the risk is hedging too early, which also comes at a cost. To solve this conundrum, investors can build a systematic solution using dedicated structured products.