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Three Ways to Reduce Stock Losses

Anyone who owns stock knows this year has given us pain with no gain. Since its peak in October of 2007, the stock market has dropped by about 40 percent, and not even the oracles of finance can determine if we've seen the bottom yet.

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There are different strategies to hedge your bets and reduce losses on a diversified stock portfolio or on an individual stock, depending on how bearish you are and when you think the market will recover. None of these strategies is for the faint of heart, however, and you will need to invest time in making sure you understand them, or find a trusted adviser who can explain them to you, as well as execute them.

Three strategies -- negative correlation funds, protective puts and equity collar options -- are all designed to reduce losses from short-term market volatility, or protect you from steep losses if you have a large position in a single stock.

The key to success is finding the right strategy to fit your personal risk profile, time horizon and the amount you are willing to pay for protection. And you must realize the gambles inherent in each strategy. You may reduce your market risk, but there will be other risk, such as interest rate risk.

"In order to get reward, you have to take risk, but it has to be measured risk," says Clare White, a chartered market technician and a technical analyst for Optionetics, an investment education and trading Web site. "It's so important in this market to know how to protect your portfolio."

Negative correlation ETFs
Investors who heeded the call to diversify into a portfolio of small cap, midcap, large cap, value, growth and international equities have seen a fairly uniform result over the past year. All have lost value.

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Historically, when one or more of these asset classes was down, others were up, maintaining the portfolio on an even keel, or steadily gaining in value. But when the entire portfolio is trending downward, one of the easiest methods of hedging is to buy negative correlation exchange-traded funds, or ETFs, also called inverse funds, which are available from companies like Rydex, ProShares and Profunds.

These funds "short" the market, using a variety of strategies that mutual funds are not allowed to use, including leverage and derivative trading, depending on the specific fund.

When you own stock in a mutual fund, you are considered to be "long," so the short funds theoretically hedge your bet with alternative strategies in case the stocks in your long funds decrease in value.

"Since 2000, I've been calling the buy and hold strategy 'buy and hope,'" says Moe Ansari, president and chief portfolio manager of Compak Asset Management in Irvine, Calif.

He advocates reducing those aspirational aspects of "buy and hope" by balancing portions of a long portfolio with short ETF funds. By looking at the areas of your portfolio that have become overweighted, say large-cap growth stocks, an investor can choose to hedge a portion of that particular asset class by buying a negative correlation fund for the corresponding index or sector, in this case the Standard & Poor's 500. Negative correlation funds are also available for the Nasdaq, the Russell 2000, the Dow, as well as in various sectors like emerging markets. "It will not be a perfect hedge," Ansari says, but he likens it to "having a brake and accelerator on your portfolio" because you're controlling exposure to market risk to some extent.

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