To Hedge or Not to Hedge

Submitted by Jamie A. Upson on Tuesday, March 6, 2012 - 3:00pm
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Should you hedge your stocks against another market rout? With hedging, you buy something that offsets or reduces your portfolio’s risk.
 
There are varying degrees of hedging. One is partial hedging, which means you take some risk out of portfolio and cover a piece of it, or full hedging, where your goal is to eliminate all risk, closely resembling the effects of going to cash. You can also hedge constantly, or only hedge when you feel risks are higher than normal. 
 
Who should consider hedging strategies? Someone who:
 
1.      Is concerned that the stock market will experience a large selloff, again.
2.      Believes that market timing is possible.
3.      Has taxable assets that have appreciated, and who wants to reduce risk without selling everything and incurring the tax liability.
4.      Does not have time for his or her portfolio to recover after sizeable losses.
5.      Believes that the key to making money is not to lose it in the first place. 
6.      Is willing to give up some of the upside in order to protect against the downside.
 
My firm has been managing money for over 30 years. About four years ago, after talking to some of our clients, we concluded that most of them could relate to some or all of the statements above. So we added a hedging strategy to our asset management process. 
 
That leaves the question of why, when and how to hedge:
 
WHY
The primary reason to do it is to help clients preserve capital when risks are higher than normal.  Most investors find buying securities easier than selling them. Very few investors have the discipline to sell. Their approach is like driving a car with only a gas pedal. With no brake, you need to be very careful.
 
WHEN
 
Hedging is most effective if used when you believe risks are higher than normal. A lot of investors already use this strategy in a reactive way, not before something goes wrong but after.  The last time we saw this was in 2008. As the market trended lower, more and more investors sold their stocks and moved to cash because they could not bear to lose any more. For most, this was an emotionally driven, reactive response.
 
A more effective way to handle this is to define, in advance, what trigger points must be reached before you take action.  
 
My firm outsources this analysis to a quantitative firm that for 30 years has specialized in risk analysis and trend following. For the do-it-yourselfers, make sure that you identify your own trigger points to take action. Then, without being driven by emotion, you will know when to hedge and when to release the hedge. 
 
Here’s an example: If the market falls by 10%, add a partial hedge. If the market falls 20%, add a full hedge – that is, for your entire portfolio. When the market climbs back by 10%, return to the partial hedge. After the market rises 20%, release the partial hedge. Now here is the hard part: Follow the plan. Discipline is the key ingredient that divides winners from losers.
 
I have a good friend who is a brilliant portfolio manager. He told me a story that I think about often. He has a couple of signals that he uses to help determine when to buy and/or sell securities. He followed one of these signals nine times in a row and each trade resulted in losses.  When he got the signal for the 10th time, he decided not to place the trade. It turns out that if he had placed that trade, he would have made up for the prior nine trades, and then some.
 
HOW
 
The classic ways to hedge are using put options and futures contracts. Fewer investors are familiar with them. These are complicated and at times volatile. Professional and institutional traders dominate these fields, meaning you are an amateur playing in the big leagues. Not an ideal situation for you.
 
With puts, for instance, you pay a fee called a premium to maintain a sort of insurance on your stocks. When a stock you own drops to a certain level, say $20 per share, your put contract means you sell it there and pocket the $20. That protects you should the stock plummet to $10. But paying premiums for sustained periods can get expensive. And what if your stock rebounds to $25 in two days? You lose out.
 
When we hedge, we use what are called inverse funds, also known as bear funds. They are easier to buy and cheaper to maintain. These vehicles, which use short-selling and other techniques, aim to move in the opposite direction from the market. If stocks slump, inverse funds are supposed to rise.
 
PROS & CONS
 
Like most things in life, there are tradeoffs to reckon with. If the pros outweigh the cons, then it is still worth pursuing. Understand that, when the cons present themselves, you must remain disciplined for the strategy to work.
 
For us, the biggest challenge is to watch the market go higher when we are hedged. Your trigger points will not always be right. Accept it and move on.  When it is right, your portfolio is saved from a devastating blow that could take years to recover from. 
 
Jamie A. Upson, CFP, CMFC, AAMS, is the vice president of Wealth Management Group in Danvers, Mass.
 
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