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Monday, 10 December 2007

Time to Think about some more Market Insurance

The Australian stock market has been trading sideways in a volatile manner since mid-year. No-one really knows if the US economy will succumb to the credit squeeze caused by the sub-prime lending fiasco, and draw the global economy into a slump, inducing a bear market. Or whether the US economy will scrape by avoiding recession, and the continue strength of the BRIC economies and Asia will push the Australian market to new highs.

Overall, after several years of double digit returns, I feel it's prudent to reduce my level of gearing from around 60% overall, to a lower level, perhaps even ungeared. However, I don't want to realise any capital gains this financial year (ie. prior to 30 June), so I need to look at some form of insurance against major losses if there is a significant fall in the market before I sell some stocks and reduce my margin loans.

I bought 7 All Ords Index Put options back in June, which would have offset most of my portfolio losses if the market index dropped below 6,500, but the options expire this month. I could buy some similar options that would offset any significant drop in the market (say, more than 10%), for a cost around 2% of my portfolio value. There are other avenues such a warrants, or even using CDFs to short-sell an ETF such as the Commonwealth Diversified Share Fund. I'll have to crunch some numbers to see which how much each alternative would cost to provide similar protection. These choices also have different features. For example, once I've bought XAO put options they would remain 'in force' until the expiry date. If the market rose they would simply decline in value. In contrast, if I sold CDF CFDs and the stock price rose I'd soon face a margin call to keep the position open.

On the other hand, I don't really believe in "market timing", and my investment plan is to remain invested for the long term and to use gearing to (hopefully) produce improved returns (at higher risk) over my investment timeframe. It's just that the series of interest rate hikes over the past few years have raised the interest rate on my margin loans to around 9.5%, which makes it less likely to be a worthwhile strategy (given the long-term overall returns from the Australian stock market are around 9-12% pa). Also, the recent changes in superannuation rules and the ability to invest in CFDs within the tax-advantaged superannuation system, make it attractive to move funds out of geared direct stock investments and into my SMSF. Using negative gearing (outside of the superannuation system) still provides some attractions via the ability to reduce taxable income and "convert" it into long-term capital gains. This is more beneficial than it might appear from simply looking at the income tax rates, as lower taxable income will impact on capital gains tax rates, access to the superannuation co-contribution for undeducted contributions and eligibility to Family Tax Benefit.

Copyright Enough Wealth 2007

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