How to Protect Your Portfolio

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The trick to making money from inverse funds is to invest in them before stock prices start to fall, says King.

A Healthy Margin

Having been caught in the downdraft in October, 1987, losing a lot of his clients' money, Joseph Biondo Sr. believes in keeping portfolio protection simple. Since the large amount of money borrowed on margin to boost positions was a key contributor to both the 1929 and 1987 crashes, "we limit the amount of margin we'll have a client use to 20% instead of the 50% cap that regulations [allow]," says Biondo, the founder and senior portfolio manager of Biondo Investment Advisors in Milford, Pa.

For a client who has put up $100,000 to buy $200,000 in stock, it takes just a 50% drop in the market to wipe out the initial investment and force the investor to use the remaining $100,000 to pay back the loan. "We'll only borrow 20% to buy stock, so essentially stocks have to go down 80% for a client to be bankrupt instead of 50%, and that's never happened," he says.

Hedging with Exposure to All Asset Classes

There seems to be an unspoken belief in the financial industry that history repeats itself, but Bill Neubauer, an independent financial planner in Miami, says he tries to position his clients for crises that haven't been seen before.

For Neubauer, the only way to really minimize risk is through extreme diversification, by adding more asset classes that behave differently from one another. Four years ago, he began adding real estate to clients' portfolios. Then he began to shift toward greater international exposure in all asset classes, expanding from stocks to include bonds, currencies, and real estate. International assets now account for 70% of his clients' portfolios, which total roughly $30 million.

"For them to have a hedging function, they have to be in fairly meaningful quantities," at least 5% of the total portfolio, he says. "The thing people really worry about is correlations and negative correlations being tossed out the window when everything goes down at once." Dispersing his clients' portfolios among five or six major asset classes and 18 subclasses has produced a much smoother ride, he says.

Targeting Vulnerable Sectors

Investors can also hedge based on a belief that one type of stock will do worse than other types under certain economic conditions. Team, of Team Financial Strategies, invests in inverse funds that track the Russell 2000 index because he thinks an economic downturn would be much harder on smaller-cap companies. But he balances that by concentrating his long positions in a small number of stocks that are owned by a few value-oriented fund managers he trusts and that trade at a discount of at least 30% to multiples like price-to-sales and price-to-earnings.

Exchange-traded funds that target particular sectors are another sharp tool for building protection into a portfolio. Kipley Lytel, managing partner at Montecito Capital Management in Montecito, Calif., has been buying shares of UltraShort Financials ProShares (SKF), an inverse index ETF, on the belief that financial stocks are overpriced and still vulnerable to the credit crisis. "So as financials go down, we'll make money." Montecito's portfolio also includes hard assets like commodities, as well as high-yield and hybrid equity funds, like Hussman Strategic Growth Fund (HSGFX), that can buy index put options.

The burgeoning portfolio protection strategies probably deserve most of the credit for keeping a lid on irrational exuberance, but the additional caution may also reflect the aging of the biggest investor population, the baby boomers. "They're a little more senior and mature. There's a realization that sensible returns—between 7% and 15%—are acceptable, where there was time in the 1990s and late 1980s when people wanted high 10s, low 20s returns," says Biondo. "As people get a little smarter and older, they realize that's not reality and that if you get those types of returns, they're short-lived."

Bogoslaw is a reporter for BusinessWeek's Investing channel .