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Nicola Guida
Nicola Guida
Articles (20)  | Author's Website |

Downside Protection: How Do We Handle It?

Managing risk and emotions in times of panic and fear

March 15, 2020 | About:


I’ve found that when it comes to downside protection, everyone has a different perspective and approach.

I’m probably not an expert on it, but, like every investor, I had to take my decisions on how to handle the inevitable risk that remains even after having applied all the sound value investing principles we often talk about on GF (to the best of my abilities), so I’d like to share my thoughts and experience on the topic.

For several years during the recent long bull market, and especially when I felt that prices where going through the roof, I have been thinking about how to protect my invested capital. Which kind of risks do we really need to protect from? In my opinion, it always boils down to the following two:

1) Risk of permanent capital loss

2) Risk of inadequate returns

As value investors, we should not be worried about volatility. On the contrary, volatility is our friend, because it is closely related to overreaction. And this, in turn, means having the opportunity to buy at very cheap prices and/or selling at ones which are above our estimate of intrinsic value.

Risk management is all about planning

We should not try to handle risk while the events we want to protect from are unfolding, as it is usually too late. Risk can be correctly handled only if we plan for it ahead of time.

Managing risk for value investors means, first of all, buying for less than intrinsic value and with an adequate margin of safety.

Another technique we often use is diversification, in order to protect us from anything that can happen to a precise company (or industry), which will by definition not harm our whole portfolio, resulting in capital preservation.

While these two approaches (one belonging to the old Graham framework and the other to Modern Portfolio Theory), if correctly applied, are proven to be effective in minimizing risk related to both the above mentioned categories, there can still be unexpected macro events, like the one we’re facing right now, that can affect our long-term returns (not to mention our health and that of our loved ones).

For those who have been through the 1999 dot-com bubble and the Great Recession (2008-2009), in times of crises it is usually simpler to be emotionally insulated and resist the urge to panic. If we continuously look at the red lights appearing on the screen in situations like the present one, we may start to think that we failed to correctly do our homework, and we could consequently feel the urgency to sellone or more stocks that we previously carefully analyzed and bought for less than their worth and that are now crashing because of fear and irrationality.

The right experience and education can give you confidence, and panic and fear eventually revert back to business as usual (and so do stock prices).

But as experienced investors know, we should at the same time not discard every selloff as a temporary issue and simply close our eyes waiting for the clouds to dissolve. Even if things go back to “normal” on aggregate, every crisis is different and can potentially hit any sector or any aspect of our lives.

As we go beyond the overreaction and analyze the events by keeping a cool head, we may realize that some business sectors were punished more than deserved because the actual impact is less severe than projected, while some of them can be justifiably marked down as their prospects may have been compromised at their very roots.

Even if that is not the case, highly leveraged companies can be simply forced to bankruptcy because the downturn is too long for them and they cannot keep up with debt repayments. These companies are no different from people who have big mortgages compared to their possibilities and/or that run their credit cards to the limit and live paycheck by paycheck. They simply have no margin left; everything must go perfect in order for them to succeed.

Insuring against risks

If a completely unexpected event is damaging the ability of one or more companies we own to succeed (even if we carefully analyzed and bough them cheap before), it would be nice to have in place a sort of insurance that protects us from such scenarios.

While the modern finance industry provides us with plenty of different methodologies to (fully or partially) protect us from unpredictable scenarios, we don't necessarily need to implement complex strategies in order to get the right level of protection. Actually, what is unpredictable is only the type of event, not the fact that such an event will one day occur!

As virtually all my invested capital is in U.S. stocks, I simply choose an instrument that appreciates when the global U.S. market goes down. In my specific case, it was a PUT S&P500 Covered Warrant with a strike value of 2500 (expire month is September 2020), bought in October 2019. The actual instrument used is not important for this discussion, and I am sure that anybody could suggest alternative options.

Actually, I've been buying such a security for several years (approximately once every 1.5-2 years). Was I disappointed to see it going down in price and become almost worthless over time during the past years? Of course yes, but I was also happy to see both my portfolio (aggregated) price and value appreciate over time.

It is no different from buying car insurance and not having an accident that year. Would anyone be so crazy as to wish to have an accident in order to be paid by insurance? In the same way, nobody would like to see their portfolio being marked down just to see the downside protection instrument to go up.

Why is this the case? Because if the portfolio goes, up the “insurance” only reduces its return by a little, while if it goes down, all the instrument does is protect the downside.

In any case, these kind of securities should only be used to reduce risk, and not for speculative reasons. For example, some years ago I was convinced that Apple (NASDAQ:AAPL) was going to increase in price in a very short time, so I bought an Apple Call CW having a strike price higher than the current market price. The stock went up and I earned what at that times was quite a lot of money for me, considered the little invested capital and the short time employed to earn it.

After that experience, I never bought such an instrument again without having a “collateral” (which, in the case of a put CW, would mean "without owning the corresponding stock"). The reason is because as my education as a value investor progressed over time, I realized how much risk of permanent capital loss I took on with that hazardous move. Earning money that way is just the luck of the draw, and it cannot be defined as investing.

Indeed, every time we hope to earn money just because the price satisfies some numerical constraints within a certain time window, and not as a result of sound investment principles, we are speculating, and speculation, apart from and above any other consideration, almost always ends up in permanent capital loss.

My downside protection mechanism is working quite well during these crazy selloff days, not because I'm “in the money” yet (as the S&P only just reached the strike price) but because of the time value of the instrument. I would not use it and feel free to sell all the stocks of my well-studied portfolio just because their prices went down.

I will use the money only to compensate for the losses that have been taken. In other words, I will sell a stock (or reduce its size in my portfolio) only if my investment thesis does not hold anymore (i.e. if my estimate of intrinsic value decreased because of fundamental reasons). Actually, this is something we should always do! The only difference here is that I can now afford to compensate for these losses because of downside protection.

Finally, we know that holding an adequate amount of cash is the best way to “go from defensive to offensive.” To better understand why, I strongly recommend reading one of Thomas Macpherson´s latest articles, “The Enduring power of Cash," which you can find here.

I am planning to add to my existing positions and/or to buy companies that I love but which I considered too expensive before.


Whatever strategy you will choose to protect your investments from unexpected events, it is very important to think about it (and plan for it) in good times, when everyone is happy and these options are cheap and abundant. This means slightly reducing our returns during bull markets but having a way out (and more freedom) in the case that unpredictable events will occur.

I would love to hear your thoughts on downside protection!

Disclosure: Long Apple (NASDAQ:AAPL).

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About the author:

Nicola Guida
I'm a Software Engineer with a big passion for Value Investing. I love looking for undervalued companies both to feed my investment pipeline and to write articles in order to share my investment thoughts.

Visit Nicola Guida's Website

Rating: 5.0/5 (4 votes)



Appspopo7 - 1 month ago    Report SPAM

Thank you so much for this. I was into this issue and tired to tinker around to check if its possible but couldnt get it done. Now that i have seen the way you did it, thanks guys

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