At least grab your umbrella
What now if you think the market is due for a correction? How do you make gains when market goes down? Warren Buffet is quoted as saying Rule Number 1 is “Never Lose Money.” Occasionally markets go through periods of extreme volatility and declines. It’s easy to ride out small fluctuations when you have a long time horizon. But in the case of large declines, experienced investors like to seek protection or hedge. Considering the correction that just happened, it’s never bad to consider a hedge.
In fact for active investors, hedging might be considered as another form of diversification. Similar to having a bond or gold allocation, having non-equity-correlated or inversely correlated assets can improve returns. So how does one hedge? There are many ways; each with pros and cons so there is no strategy that’s always right or wrong. Here are some common approaches.
Stay in cash
One simple strategy is to sell some equities and move to cash. Cash doesn’t lose value in the very short term and can be quickly redeployed when you think the time is right. Of course, this is less a hedge and more avoidance. And cash is generally a poor long-term option since market timing is difficult to get right, and meanwhile, you lose out on any asset returns. Selling into cash may stem potential losses but leaves zero chance of gains. Market timing is virtually impossible. If you guess right on the exit, when do you get back in?
Trading into defensive sectors and assets like consumer staples, utilities and bonds is another strategy. But like cash, this strategy is more a mix between tactical diversification and hedging rather than a true hedge. It’s perhaps the most practical and comfortable option for many since it maintains exposure to assets but tactically shifts the portfolio to favor low or negative beta assets. But it is simple to execute before and as an actual decline happens. In designing more active hedging strategies, investors can choose from a variety of tools and approaches. Each has pros and cons.
As the most liquid of all assets, cash acts as a source of psychological comfort for investors. The findings from the BlackRock Investor Pulse Survey illustrate this perfectly, as can be seen in the graph above.
As you can see, 29% of respondents felt that saving cash made them feel hopeful, whereas 39% maintained that they prioritize holding cash reserves over investing. Meanwhile, 39% of respondents stated that cash made them feel “secure,” and 28% felt that cash made them feel “confident.” Holding cash gives investors psychological comfort, creates a safety net for emergencies, and accords them flexibility.
However, cash may not be the best hedging strategy for the long term. This is simply because idle cash reserves tend to lose their value over time. Inflation erodes the purchasing power of your cash reserves.
The above graph shows the compounded annual returns of cash, stocks (as represented by the S&P 500) (SPY) (SPUU), and bonds (TLT)(BND), after taxes and inflation, over the period from 1926–2014. Cash fell woefully short of both equities (VTI) and bonds, with a meager total return of 3.5%. Returns after tax and after inflation totaled a measly -0.8%.
As this graph shows, Americans are not ready for retirement and cash is not sufficient to meet the post-retirement financial goals of investors. This means that although cash and defensive plays may be good short-term hedging techniques, they hold very little merit over the long term.
In the next part, we’ll discuss other strategies.