I received an insightful question regarding portfolio protection. I’m posting it here in its entirety along with my response to see if we can all learn about the perks of buying puts to safeguard your account.

I was talking with one of my co-workers about index funds and investments, and I started thinking about how would one protect their index fund investments. Put options came to mind. However, when talking about them, the following long question came about:

“Why would I use put options? If the market crashes, I’m dollar cost averaging as it goes down since my purchases are monthly via my paycheck. Ultimately, when the market goes up, and it always goes up, I would capitalize on the shares I bought on the cheap.

Additionally, buying a put costs money – a decent percentage of your total investment would be going to pay the put premium, like a fee. We all know fees are bad, even a 1 or 2 percent fee per year can cost you hundreds of thousands by retirement. If you’re paying for this Put each year, you’re basically paying a 2-4 % fee each year, reducing the potential value of your retirement nest egg.

Should I do that rather than just investing in the SPY or a similar index fund and dollar cost average my way to retirement?”

I couldn’t think of a good answer to that. I’m actually struggling to find a reason to just buy a put yearly on a long term investment unless you were subsidizing the cost of the put by selling covered calls on the SPY.

But if I didn’t plan on doing covered calls on the SPY or any cash flow strategy, is there a reason to buy the put?

And now, my response.

I agree that always owning puts on a stock portfolio without coming up with a strategic way to at least partially finance the protection will act as a serious drag on the long run performance. And, I say as much in the Bear Market Survival Guide. The route I prefer is to either sell covered calls in addition to the put purchase (which we do in the Bear Tamer system) or to be more tactical about when to buy the insurance.

We offer three advantages to buying portfolio protection in the Bear Market Survival Guide. I want to highlight two of them here: higher allocation to stocks and sabotage avoidance.

Stock Up, Investor

If you can limit your downside to a mere -10% to -15% then you will probably be willing to put a greater percentage of your portfolio, maybe even all of it, into stocks. The traditional investor who is unwilling to stomach a 30% to 50% decline must of necessity diversify some of his capital into safer, but lower rewarding assets like bonds.

This is particularly true with those that have amassed a lot of money. I think the dollar cost averaging and maintaining a long-term focus without fiddling with buying puts approach is an easier path when you’re young and don’t have much capital. But what if you have $100k, $250k, $500k, or $1 million? The impact of each month’s investment on the overall portfolio diminishes the larger your nut grows. Adding a few hundred bucks or a thousand bucks a month during a bear market when your million dollar portfolio just got cut in half doesn’t move the needle.

My first answer to why buy puts, then, is it allows me to invest more in the stock market than I otherwise would because of my risk tolerance.

Sabotage Avoidance

The cardinal sin of passive investing is panicking and selling stocks in the depths of a bear market. It’s a mistake that very few can come back from. Your propensity for panic is inextricably linked with the magnitude of loss. As the red numbers grow larger, so too does the itch to jump ship. What’s particularly scary to a passive stock investor is that the potential loss is an ominous question mark.

Is the next bear market going to see a drop of 20%, 30%, 40%, 50%, or worse? No one knows. We can use historical precedence to frame expectations, but that’s about it. Compare the emotional fortitude of someone whose risk is unknown to that of an investor who knows the most pain a bear market can inflict is -12%.

It’s easy to say you’ll stay the course when the chips are down, but many find it more challenging than they anticipated.

The second benefit to owning puts, then, is it makes it easier to avoid self-sabotage. Admittedly, you could say that proper asset allocation is an alternate solution to this dilemma. I highly doubt that someone who has 20% of assets in stocks and 80% in bonds is going to puke during the next bear market. But, then, they will also have lower long-run returns due to their minimal exposure to equities.

These are probably the two simplest answers. Admittedly, there are others, but we’ll save them for another day.