How to Protect Your Portfolio From a Market Crash

Although the daily ups and downs of the markets can be a source of worry for many investors, the specter of a worldwide economic meltdown looms as a real possibility for some. If this happens, years of hard-earned savings and retirement funds could be wiped out within a few days or even hours. Fortunately, there are several things that you can do to shield your assets from a global economic depression or market crash. Preparation and diversification are the key elements of a sound defensive strategy that can help your nest egg to weather a financial hurricane.

Diversifying your portfolio is probably the most obvious measure that you can take when it comes to shielding your investments from severe bear markets. Although it may be a good idea for you to have the majority of your retirement savings in stocks or stock mutual funds or exchange-traded funds (ETFs) at the moment, you need to be prepared to move at least a good portion of your funds into something else if you see a global crisis looming. Stocks, bonds, cash, real estate, derivatives, cash value life insurance, annuities, precious metals and perhaps a few carefully selected alternative holdings such as a small interest in a producing oil and gas project can most likely ensure that you would have at least something left in some of those categories if the bottom really falls out. (See also: Diversification: Protecting Portfolios from Mass Destruction.)

Whenever there is real turbulence in the markets, most professional traders who did not have to buy or sell in before the storm will quickly move to cash or cash equivalents. You may want to do the same thing, at least if you are able to do so before your portfolio hits bottom. If you get out quickly, then you can get back in when prices are much lower. Then, when the trend eventually reverses, you can profit that much more from the appreciation. (See also: How to Profit From Market Volatility Using ETFs.)

Although you probably shouldn’t have all of your savings in guaranteed instruments, it's wise to keep at least a small portion in something that isn’t going to fall with the markets. If you are a short-term investor, then bank CDs and Treasury securities are a good bet. If you are investing for a longer term, then fixed or indexed annuities or even indexed universal life insurance can provide superior returns than T-bonds. Callable CDs, corporate bonds and even preferred stocks of blue-chip companies can also provide competitive income with minimal to moderate risk. (See also: How to Create a Laddered CD Portfolio.)

If you see a major dip on the horizon in the markets, then don’t hesitate to set yourself up to profit directly from it. There are several ways you can do this, and the best way for you will depend on your risk tolerance and time horizon.

If you own shares of stock that you think are going to fall, then you could sell the stock short and buy it back when the chart patterns show that it's probably near the bottom. This is easier to do when you already own the stock you’re going to short, because this way, if the market moves against you, you can simply deliver your shares to the broker and pay the difference in price in cash. (See also: A Beginner's Guide to Hedging.)

Another alternative is to buy put options on any stocks that you own that have options or else on one or more of the financial indices. These derivatives will increase enormously in value if the price of their underlying security or benchmark drops in value and can substantially reduce your total losses.

If you have substantial assets and liabilities, then you may be better off by liquidating some or all of your holdings and paying off your debts if you see bad weather approaching in the markets. This is especially smart if you have a lot of high-interest debt such as from credit cards or consumer loans. This can at least leave you with a relatively stable balance sheet while the bear market roars.

Paying off your house may be another good idea, or at least a portion of your mortgage. This also can be especially effective if you are currently paying private mortgage insurance on your loan. If you pay off a chunk of your mortgage, then you may also be able to refinance to get a better rate and lower your house payment. (See also: Expert Tips for Cutting Credit Card Debt.)

If you are not able to directly shield your investments from a collapse, there are still several things you can do to take the sting out of your losses. Tax-loss harvesting is one option for the losses you have sustained in your taxable accounts; simply sell all of your losing positions and buy them back 31 days later (which means that you will have to sell them before the end of November in order to realize the loss before Jan. 1, so check your calendar first). Then you can write all of your losses off against any gains that you have realized in those accounts. You can carry forward any excess losses to a future year and also write off up to $3,000 of losses each year against your ordinary income. (See also: Tax-Loss Harvesting: Reduce Investment Losses.)

If you own any traditional IRAs or qualified plans from former employers that you are able to move, consider converting some or all of them into Roth IRAs when their values are depressed. This will effectively reduce the amount of the conversion—and thus the amount of taxable income that you must declare. A 30% drop in the value of a $100,000 IRA means $30,000 that you will not have to pay taxes on if you convert the entire balance in one year. This strategy is a particularly good idea if you happen to be unemployed for part of all of the year, because you may be able to keep yourself in one of the lower tax brackets even with the conversion income.

Although market crashes and depressions are usually going to be bad news for your portfolio, there are several things you can do to minimize your losses or even profit outright from the market movement. Diversification, liquidity, derivatives, short sales, and tax-loss harvesting can all be used to shore up your portfolio when the chips are down.

For more information on how you can protect your portfolio from economic collapse, consult your financial advisor. (See also: Rebalance Your Portfolio to Stay on Track.)