Hedging, for some investors, sounds complicated. In reality, it’s not because it’s all about reducing investment risk. Who can’t understand that?
Sometimes stock prices go up, sometimes they go down. That’s how financial markets work. But over the past 8 years, stock prices have enjoyed consecutive yearly gains by making one all-time high after another. How can prudent investors hedge their money and retirement assets? Let’s examine a few hedging strategies.
One of the easiest way to hedge a portfolio when market prices have climbed is to simply re-allocate capital. That means selling portfolio assets that have risen substantially in value and re-deploying that money into other groups that may have bright potential for growth, but may be temporarily underperforming. For example, reducing exposure to stocks (NYSEARCA:SCHB) – an area that has performed strongly – and adding market exposure to commodities (NYSEARCA:DBC) – an area that has performed weakly – is an example of re-allocating capital.
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Re-allocating capital is a strategy that can be applied with highly appreciated individual stocks or other assets that have been held for a very long time. In many cases, the growth of these assets has probably caused your investment portfolio to become more concentrated in these highly appreciated assets, thereby increasing your portfolio’s volatility and risk.
Margin of safety
The “margin of safety” idea was originally hatched during the 1930s by Benjamin Graham and David Dodd, the founders of modern day value investing. Although their idea was applied to selecting individual stocks at undervalued prices, Dodd and Graham’s principles about safety are applicable to managing a portfolio of investments.
In the context of the individual investor, your “margin of safety” represents the capital or money that you absolutely cannot afford to risk to unrecoverable market losses. This money gets set aside from your core and non-core portfolio to be invested in fixed accounts with principal protection, guaranteed income, and liquidity. The prudent investor does not wait for a financial meltdown or stock market crash to establish a margin of safety.
As part of ETFguide Premium, we provide you with a Margin of Safety worksheet to help you quickly determine a portfolio cushion that is comfortable and compatible with you.
Why do people buy insurance on their homes, lives, and cars? They do it to protect themselves against loss. Similarly, investors can protect their investments from loss by purchasing put options on funds or ETFs that they own.
Because put options are designed to increase when market prices fall, any portfolio losses from investments that have decreased in value would be offset by market gains in the put options (or insurance) that you bought. Contrary to some, buying put options is not gambling, if it’s done correctly and within the framework of your overall investment goals. And if the objective of buying puts is to protect some or all of your investments against the potential of market losses, then it’s a prudent exercise. If prudent people protect their physical assets, why shouldn’t they likewise protect their financial assets?
Hedging is a smart strategy. It gives your portfolio a cushion and helps you to manage market volatility by dialing down risk. When is the best time to hedge? When market conditions are favorable, not when it’s raining cannon balls!