After several years of much-needed stability, volatility has reemerged in the equity markets in a big way, according to a new analysis from investment management and financial services firm Gerstein Fisher. As demonstrated in the analysis, recent global news events and other macroeconomic forces have driven the Volatility Index (VIX) of implied S&P 500 Index volatility to a value of 14.52—up about 17% from early June. This and the long bull market the U.S. has experienced since 2009 have caused many investors to regain interest in forms of downside protection for their stock portfolios (see “Investors Want Smarter Volatility Management”).

“Does this mean we’re in for a pullback? I have no idea,” says Gregg Fisher, chief investment officer for Gerstein Fisher. “We make no attempt to time markets or to divine the future at Gerstein Fisher. But investors should prepare for a correction and avoid making fear-based decisions in the event of one.”

Fisher urges long-term investors, like those participating in workplace retirement plans, to keep in mind that market corrections are a normal and even healthy aspect of embracing risky assets such as stocks—without them, investors would not collect a risk premium for equity holdings. Still, everyone would like to find an investment strategy that allows for strong growth on the upside while also limiting damage when the markets turn south, he says.

Fisher says one popular approach, especially among institutional investors but also among more active and affluent individual investors, has been to purchase “put options” to hedge the downside risk within a stock portfolio. The approach can be effective for limiting catastrophic losses, Fisher explains, but the cost of purchasing put options has crept up in recent days with market volatility.

“The cost of insurance usually rises when everyone wants it,” he explains, “but by historical standards the current cost of buying puts is still quite modest.”

Fisher points to the relatively simple example of a $1 million portfolio of diversified stocks to explain how put options work.

“We’ll use the exchange-traded fund SPY, which tracks the S&P 500 Index, as a proxy for the stock holdings,” he writes in the analysis. “If you’re particularly anxious and would like to hedge the risk of the portfolio dropping by more than 10% in six months, you could purchase out-of-the-money put options on SPY, which would have cost $13,750 on July 21, or 1.38% of the portfolio value.”

The cost for hedging against even more significant losses—say, to protect against 25% or even 50% market declines over the next 12 months—is actually even lower, Fisher explains. To purchase enough put options on the SPY portfolio to hedge against a 25% decline in one year, an investor currently pays about $13,133, or 1.313% of the portfolio value.

“For protection against a 50% decline, you’d fork over just $1,900, or 0.19%,” he explains. “But as a general rule, the worst time to buy an option is when you want to buy an option.”

“What I mean by this is that when volatility is high in the market and investors are nervous, they tend to go shopping for insurance at the same time,” he explains. “Remember that with a put option you’re purchasing downside protection for only a limited time period. You could roll over the put contract [on a yearly basis], but this tactic is expensive and will depress your equity portfolio’s long-term returns. If you are saving and investing long-term for retirement, it seems counterproductive to purchase puts to protect against potential short-term losses, given the costs of doing so.”

This fact has led to increasing attention being paid to “the variable annuity approach to acquiring downside protection,” Fisher says, especially among those nearing retirement.  

“We know that, long-term, stocks are generally a very good investment that will maintain or increase your purchasing power in retirement,” Fisher says. “But the memory of two market crashes in the past 14 years is etched into your brain. As a way of hedging your bets, you could sell your equities and with the proceeds purchase a variable annuity that offers a level of guaranteed income in retirement.”

The issue, as with using options to minimize potential losses, is that the investor is surrendering much of the potential market upside to pursue protection on the downside. This, in turn, suggests a third approach to downside protection, which is to modify your asset allocation, Fisher says.

“Each client situation is unique, but generally speaking we prefer to implement an investment allocation with careful attention paid to risk instead of the relatively expensive and complex instruments of options or annuities,” Fisher says. “To be clear, I am speaking of shifting allocations in the portfolio to match long-term objectives, not because you fear the market may shed 10% or 20% in the coming weeks. To repeat, we do not believe in market timing.”

For example, by increasing the fixed-income allocation and reducing exposure to equities and other risky assets, an investor can narrow the range of expected returns and thereby cut portfolio volatility. “But this peace of mind also comes at a price,” Fisher warns.

As part of the analysis, Fisher also elucidated the long-term effect of switching from a portfolio with 60% invested in equities and the remainder in bonds to one with a 40% equity allocation.

“Using the S&P 500 Index to represent stocks and five-year Treasuries as a proxy for bonds, we back-tested both portfolios from January 1926 to June 2014 and rebalanced quarterly,” Fisher explains. “The result is that the more conservative 40/60 portfolio was nearly 30% less volatile, but returned 7.78% annualized vs. 8.75% for the 60/40 blend.”

The 0.97% per year performance gap adds up when compounding wealth over time, Fisher explains.

“For instance, assuming the historical results we just cited, after 20 years a $1 million account invested in the more aggressive portfolio would multiply to $5.35 million, compared to $4.47 million for the 40/60,” Fisher says. “In other words, the short-term cost of switching to a more conservative allocation may seem minor compared to buying puts or annuities, but there is in fact a steep price in the form of the opportunity cost of a lower expected long-term return as a result of cutting exposure to risky assets.”

Fisher concludes the analysis by reiterating all three popular forms of market downside protection— put options, variable annuities with a guarantee, and asset reallocation—each have their place, but investors should understand that all usually come with the price of reduced expected portfolio returns.

“By all means, however, when markets are relatively placid and minds are cool, take the opportunity to assess whether your portfolio allocations are appropriate for your objectives and your time horizon,” Fisher adds. “Don’t wait until markets are in a mode of panic.”