How to protect yourself against a market crash

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Sober investors will notice that the stock market is looking a little red-cheeked and flushed these days as it lurches around its record highs, ogling a hot IPO one moment, leering at a saucy little social media play the next. Twitter? Facebook? Hilton? The market wants to plant a sloppy kiss on every one of them.

If the Standard & Poor's 500 were your friend, this would be the time to sidle up and suggest that, geez, it's getting late and maybe it's time for a little fresh air. But the stock market is not your friend. It got testy in early February, and maybe you should start planning for that inevitable moment when its mood turns really ugly.

Some investors have already braced themselves. Prem Watsa, chairman and CEO of Toronto-based Fairfax Financial, has built an impressive track record as a contrarian investor. In 2010, he raised the proportion of the company's stock portfolio protected by hedges to 100%. "We're worried about the markets coming down significantly," he said in 2011, well before the latest outbreak of investor euphoria.

So should you adopt a Watsa-like strategy? That depends on whether you just want to remove some risk from your portfolio or have the more aggressive goal of profiting from disaster.

The most prominent products for the cash-in-on-apocalypse crowd are leveraged inverse ETFs that magnify the market's return but in the opposite direction—when the market dips, they soar. Examine the details, though, and much of the attraction fades.

One issue is that these ETFs are geared to each day's market performance, and magnify twitches in both directions: If a market index rises 3% on the day, a double inverse ETF posts a loss of 6%. The ETFs also suffer from a quirk of math: If you lose 10%, you need more than a 10% gain to get back to even. So, only the foolhardy should consider leveraged inverse ETFs as a long-term holding.

You're in a better position if your goal is to just build a buffer against a market downturn. You can buy "put" options on specific stocks or market indexes that give you the right to sell that stock or index investment at a pre-determined "strike" price. Depending on the price you choose, a put can provide you with an insurance policy against market distress.

The problem is that no one sells any kind of insurance for free. Put options, for example, only last for a specified period and can be expensive. At Fairfax, the cost of employing various market hedges from 2010 through the third quarter of 2013 has run to roughly $2.9 billion. That's fine by Watsa—the money is a down payment on the profits he will protect by hedging. Not all of us would be so confident.

For most investors, a better hedge might be a stop-loss order, in which you limit your potential pain by telling your broker to automatically sell a stock if it drops to a certain level. But even stop-loss orders aren't simple. They probably won't, for instance, protect you from a market freefall that slams almost all stocks, leaving you with no buyers at your stop-loss price.

If you truly want to remove risk from your portfolio, the most effective strategy may be to, um, remove the risk. Selling some stocks and holding a larger than usual amount of cash may not strike you as a particularly clever strategy, but it's easy and foolproof. When the market is looking as tipsy as it is right now, those are virtues that clear-headed investors will appreciate

Sound investing advice from Keith Graham

North American stock markets have been on a tear since the 2008-2009 financial crisis. We asked Keith Graham, president of Rondeau Capital Inc., how he protects the $150 million in assets that he oversees in NexGen mutual funds and in private client accounts against irrational exuberance.

Why is cash king in your funds these days?

Both the Canadian and U.S. markets are trading at rich valuations. Canada is also a two-trick pony—resources and financial services make up about 72% of the S&P/TSX Composite. That's why we have 37% cash in our NexGen Turtle Canadian Equity Fund and 26% in NexGen Turtle Canadian Balanced. But we have about 30 names on our watch list that we're ready to buy [if the market pulls back].

What stocks let you sleep at night?

My focus is on buying good businesses at a good price. I'm drawn to well-financed, well-managed and profitable companies that are undervalued. Names that fit this bill now are Cisco Systems and Corning in the United States, as well as Intact Financial in Canada.

Why do you own the SPDR Gold Trust exchange-traded fund?

All portfolios should have some exposure to gold bullion, because it can act as a cash alternative, portfolio diversifier, inflation hedge and insurance against global turmoil. A 5% weighting makes sense in the light of the risks out there and the vast underperformance of gold recently. /Shirley Won