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Hedging risk in a bipolar market

How to hedge your portfolio and why.

With the stock market near historical highs, continued drama in America, Europe, Asia… not to mention South Africa, and many influential market analysts calling for an end to quantitative easing, and expecting a market correction sooner rather than later, now could be a good time to rethink your investment strategy and how to hedge your risk in this bipolar market.

It’s a fact of life that markets fluctuate. But occasionally markets experience bouts of extreme volatility and declines, which can wreak havoc on portfolios. Statistics over the last 100 years show 5% pullbacks typically happen about three times a year, 10% to 15% corrections every one to two years, and 20% bear drops every three to five years.

Traditionally, bonds have been the de facto standard to hedge against market risk, but with current bond values at historical highs, they no longer offer the kind of protection they once did.

So, how does the ‘smart money’ hedge against a market meltdown in this unique market? More importantly, perhaps we should be asking why one should hedge their portfolio?

  • Real people are emotionally driven and occasionally react irrationally. It’s well known that losing money feels twice as awful as making money feels good. It’s painful and preventing it is psychologically valuable.
  • People don’t have infinite time horizons. Are you in or close to retirement? That 10% correction or 20% bear market matters. It’s an easy exercise to research the effect on retirement plans during the subsequent year of the 2008 financial crisis bear market.
  • Distributing risk and having a solid floor is just good practice. It’s no different than paying for life or medical insurance — it’s inefficient and maybe unnecessary, but darn nice if things fall apart. Insurance is the one thing you don’t need until you need it.
  • Hedging can be considered as another method of diversification. Like having a bond or gold allocation, having non-equity-correlated or inversely-correlated assets can improve returns; remember, a 50% decline requires a 100% recovery to break even.

In many ways, we’re in unique territory and drawing from the past is limited to educated speculation rather than insightful fact-finding. After all, according to Warren Buffett, rule number one is to never lose money. You’ll want to grow your portfolio but you’ll also want to protect any gains that you do make with that portfolio. If possible, and it’s a big IF, you’ll also want to avoid experiencing any losses. That’s where the term ‘hedging’ comes into the picture.

The simplest way to think of it is that it’s a form of insurance. Hedging is simply insurance. It is not necessary and financially feasible for an investor to carry a hedge at all points of their investment but normally a crisis or a fall leaves enough tell-tale signs and scars to warrant thinking it about it. Volatility generally increases ahead of a sharp move.

Most of the sharpest falls were always a result of an event not unfolding in a way market expected it to. There is far more to this than one article can tell you, but allow me to share with you three ideas I’ve used, and have seen used by some of the smartest minds in investing:

Currency

Over the last 12 months, cash has been king in contributing to the growth of your portfolio. It’s also played a dual role of reducing volatility.

Having a solid cash allocation is the simplest approach to hedging your bets and reducing risk over the short-medium term. Of course, having too much cash can have the opposite effect by lowering your return if the market heads higher.

So, how much should you have in cash? The worst thing you can do is to have a static approach to cash allocation by picking a specific portfolio allocation like 15% and not periodically reviewing that allocation. A smarter approach would be to use a dynamic cash hedge. 

What’s a dynamic cash hedge? It’s a strategy that raises your cash allocation and protects returns during falling markets, and lowers your cash allocation and puts more to work during rising markets. The simplest way to engineer a dynamic cash hedge is to ensure you look at re-balancing your portfolio quarterly, if needed. This allows the period execution of a sale of a specific share(s) in your portfolio – for instance, when it hits a pre-determined price or what you may deem fair value. In effect, this allows you to seek safety when the going gets tough, by raising your cash allocation while also letting your winners run higher.

Defensive rotation

Rotating into defensive sectors or assets such as consumer staples or utilities is another strategy. Like the cash option, this strategy is more a mix between tactical diversification and hedging, rather than being a pure hedge. It’s perhaps the most practical and comfortable option for many, since it maintains exposure to growth assets and nets profits from them but tactically shifts the portfolio to favor low or negatively-correlated assets.

Many investors, even savvy ones, don’t understand that you can profit not only in rising markets but also in crashing markets. You can bet against the market, or a market sector. The old saying goes ‘there’s always a bull market somewhere’. An assessment of your portfolio by an investment professional can help guide you in determining where you are, and how you want to protect yourself.

The alternative approach 

Some of the best, most consistent performing fund managers…aren’t fund managers – they’re private endowment managers. An example of these are the funds owned by universities or charitable organisations. You know… the billions donated annually by the ultra-wealthy to save the polar-bear or spotted owl (‘not’ to reduce their tax burden… cough cough).

These managers are responsible for managing tens of billions of funds and we can all learn a thing or two on how they manage risk. Their ‘secret’ ingredient for consistent returns and fewer losses all boils down to how they diversify. They use investments that are insulated from crashing markets. Said another way, they’re not fully correlated to the market. They don’t have full exposure to the market and neither should you.

There’s a case to be made for alternative investments such as direct real estate investments (not Reit shares or funds), absolute return portfolios, private equity, structured notes or just holding a gold coin or diamond…or two. These ‘alternative’ strategies all come with their own risks and returns, but most importantly they come with little or no market risk. Generally speaking a 10% to 15% allocation of your money to such investments is about the sweet spot.

Unfortunately, these investments aren’t easy to procure on your own and are usually quite capital intensive, hence they’re usually restricted to 1% of this world. Technology and the development of new products in the investment sector has helped close this gap and there’s a growing number of advisors, myself included, who specialise in these types of investments.

Conclusion

At the end of the day, hedging your portfolio is all about decreasing or transferring your risk of loss. It’s a risk-management strategy used in limiting or offsetting probability of loss from fluctuations in the prices of commodities, currencies, or shares.

What’s the best approach to hedging risk in your portfolio? Probably all of the above, and more.

The game of investing is not about keeping pace with the market, or beating the market – it’s all about hedging risk so you make money regardless of the market.

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