With the Commonwealth Bank of Australia (ASX: CBA) share price and the Westpac Banking Corp (ASX: WBC) share price recently falling back from their all-time highs, it could be time to consider protecting your downside.
Why consider the downside?
It has been shown that when we own something, we are biased towards its positive features. We call this the endowment bias. For example, it's clear to me that your child is far uglier than mine.
In finance, endowment bias is the thought that our investment is better than another investment — even if the facts suggest otherwise.
Unfortunately, willing something to be better won't make you rich.
When it comes to shares, particularly those which have performed very well (think: Commbank and Westpac) we are less likely to consider their weaknesses. However, some might say this is the ideal time to consider the risks.
Recognising the risks in your portfolio is one thing, acting on them is another.
For example, most people can tell you that a fall in house prices would be very bad news for bank shares. However, aside from the obvious (selling the shares), few of these people could tell you how to protect your money against falling bank share prices.
3 ways to protect your share portfolio
Rebalance your portfolio.
Many long term investors believe it's better to water your flowers (i.e. your best-performing shares) than your weeds (i.e. the poor performers). However, if your share portfolio is more than 30% invested in bank shares, that's far too much, in my opinion. I would say that even a 20% exposure to ASX bank shares is too much.
Rebalancing your portfolio into other sectors and even internationally, is vital from a risk perspective. For example, you could rebalance into shares of companies which are not as leveraged to the housing market as banks.
Ensuring you are not overexposed to bank shares is a no-brainer, in my opinion.
Move to cash.
Lately, there's been some speculation in the press that big fund managers are moving their portfolios to cash, presumably because they are concerned about a market crash. Moving your portfolio to cash will protect your downside and give you the opportunity to buy back at lower prices. At least, that's the idea.
However, timing a market crash is not easy and I highly doubt anyone knows — with any certainty — when a crash will occur.
Use derivatives.
Most people are confused by derivatives and for good reason. Derivatives derive their value from something else. When it comes to market falls, derivatives can move inversely to prices.
For example, buying ASX put options on Commonwealth Bank and Westpac shares would be something I'd consider if I held a large chunk of my portfolio in the banking sector. They would become more valuable as the bank's share prices fell.
Foolish Takeaway
I'm not overly confident that the banks will reproduce their historically exceptional returns in coming years. And with their valuations reasonably high and multiple risks persisting (e.g. house prices, economic growth), I think it's important to ensure investors are not overexposed to the sector.
