Predicting the timing of a financial crisis, be it stock, bond, or currency, is a mug’s game. The best neoclassical models available show more false positives than Keynesian economists have wrong policies. Using ABCT doesn’t really help us with timing, either. What’s good about ABCT, more than real business cycle models and their ilk, is that it tells us when conditions are ripe for a crisis. Low central bank rates for a while now? Check. Lots of monetary ‘stimulus?’ Check. But we’ve had these conditions for a few years now. It’s hard to know when the crisis & crash will arrive.

Given the near-impossibility of timing a crisis, engaging in market timing type trading behavior is not advisable. This sort of trading carries too much risk for the expected return. At the same time, we don’t want to suffer through a crash and lose any equity value we might have built up. So what to do?

The simplest method would be to hold a portfolio consisting of only risk-free assets. Federal Treasury bonds, for example. In addition to any moral qualms one (of us) might have about this, it’s a recipe for negative real returns. So no good.

Second, we could try to find equities or corporate bonds to hold that are less sensitive to the business cycle than the typical stock. For example, Wal-Mart does pretty well during recessions, at least comparatively speaking. Such companies have low market betas, and you can find a good sample of them through Yahoo!Finance’s stock screener. The problem here is that you still will lose money during a market crash, just not as much as with a higher-beta portfolio. Moreover, there is no guarantee that historical betas predict future betas, and those future betas are the ones that matter. Finally, estimating beta is fraught with peril, so we can’t be certain the beta we estimate is a worthy measure of risk.

Third, we could combine long equity positions with long positions in assets that have negative betas. ETFs have expanded the possibilities here very nicely. There are gold and silver ETFs, along with a huge variety of others. Gold is often chosen as a ‘crisis hedge.’ One word of caution here: the gold ETFs that I have reviewed personally have low but positive betas, making them an unreliable hedge. It’s not a bad way to go but the extended long position in gold can actually hurt your returns in ‘good’ years.

Fourth, and the most complex of all, is to combine long equity positions with long positions in put options. A put option affords option holder the right, but not the obligation, to sell the underlying asset (like an index ETF), at a predetermined price. This predetermined price is called the exercise or strike price. The put option has value when the spot price of the asset is below the strike price. Formally, the exercise value of a put option is the maximum of 0 or Strike Price – Spot Price: MAX(0,X-S).

You must pay a premium to buy an option, and they do expire, so this strategy will cost you money as you roll it forward. For example, a put might cost $3/share, which would be $300 for one contract. This would protect 100 shares of stock. If you start right away, and roll this forward every month, you would be looking at $3600 for the year, give or take. 100 shares of something priced at, say, $200 would be $20000. Assume an average return of 6%, that’s $1200. So to do this technique more frequently than every three months would likely lead to losses.

The way to manage that is to buy options that are ‘out-of-the-money’ or that currently have no exercise value. These are considerably cheaper. The caveat is that these options won’t protect you from small losses. Rather, these are for the catastrophic losses that a crisis entails. So this strategy still has downside risk, but it is truncated risk. And the groovy part is, the amount of truncation is up to the investor.