Most investors make little effort to hedge against market risk.
In fact, I’d say they rarely even think about hedging…except when “rough” becomes the adjective of choice to describe the markets.
Most of the time, investors simply accept the occasional dip in the stock market as the “entry price” to make money during its rallies.
And, to be fair, the market increases over time. A long-term investor can generally ignore downturns well if they invest in good stocks to begin with and remain patient…
Then there are painful periods like right now. The losses get worse and the recovery time of the wallets increases… So much so that the cost in time can be even more damaging than the dollars actually lost.
That’s why it pays (literally and figuratively) to hedge against market declines.
The best thing about the cover? It doesn’t have to be complicated.
A few simple strategies can help you cross the line from “pure panic” to “mildly embarrassed” – and the latter is indeed the best we can aim for in a bear market like this.
Generate positive returns in any market
Alfred Winslow “AW” Jones did not resign himself to the “inevitable losses” on the way to profits. Instead, he came up with the idea of a “hedged fund” that could provide balance during tough times in the stock market.
In 1949, he started a new fund from an office down the street from the New York Stock Exchange and began pursuing a new strategy: He bought stocks he thought would rise while selling stocks short. which he believed would fall.
By betting on both rising stocks simultaneously and those that fell, Jones believed he could eliminate (or at least reduce) the “market risk” that plagues traditional investment strategies.
In other words, he believed his strategy could generate positive returns, even during times when the overall stock market was down.
Sounds pretty good right now, doesn’t it?
Jones was an interesting guy. During his formative years, he studied at Harvard University, spied for an anti-Nazi group in Berlin before World War II, met Ernest Hemingway on the front lines of the Spanish Civil War, and written for Fortune magazine.
Although these activities share no obvious connection, each of them contributed to the educational mosaic that produced Jones’ investment perspective.
Presumably, experiences like these gave Jones an understanding of both the potential rewards of risk-taking…and the associated pitfalls. Essentially, his strategy was born out of the understanding that things go wrong sometimes, even though they go well most of the time.
As noted financial writer James Grant explains:
The germ of the case for a hedged portfolio is that long-term forecasts of economic growth or interest rates or corporate cash flow are unlikely to be more reliable than the seven-day forecast on your weather app…
Hedging enthusiasts have nothing against bull markets – or, as far as it goes, bear markets. They aim to be indifferent to each while producing satisfying results in both.
The “satisfactory results” to which Grant refers are what most professional investors call “absolute return”. It is a return that does not depend on the direction of the market nor is it relative to it. It doesn’t need to feed off an uptrend.
In the decades since Jones launched his new fund, a wide variety of hedge fund strategies have emerged. While many of them still focus on buying and shorting stocks, others use a combination of bonds, currencies, futures, private equity investments, derivatives and what you have.
Regardless of the exact tactic, most hedge funds attempt to construct a “market neutral” type of portfolio that can generate a positive return regardless of whether the stock market is rising or falling.
In theory, “market neutral” strategies are the fat-free ice cream of investing. They provide at least some of the good stuff while eliminating almost all of the bad stuff.
Play defense and attack
We investors don’t need to swing for the fences every time we move forward. Sometimes it’s a good idea to shorten our swings and try to hit singles. Heck, it’s even good to hit with a pitch.
And when times get really hard, select short sales or other wallet covers like Inverted ETFs can help a portfolio “score points” when most typical investment strategies completely fall apart.
Since short selling produces profits through falling stock prices, it can be a valuable “hedge” for your conventional portfolio. Admittedly, short selling can be risky, even when part of a market-neutral transaction. But the same goes for owning stocks during a bear market.
I ran a hedge fund, so I understand that some investors have little interest in advanced strategies like options or short selling. Its good. Most of us don’t like betting against companies or the idea that we’ll lose money if a stock goes up in value.
If you are one of those who prefer more basic forms of hedging, you can consider traditional investments such as gold stocks and oil stockswhich can sometimes zigzag when the market goes down.
You can also consider “inverse funds” which move in the opposite direction of the index to which they are linked. An example: the ProShares Short S&P 500 ETF (SH). If the S&P 500 is down 1.5% on any given day, SH would be up 1.5%. You can find inverse funds on most indices or sectors.
Here’s another example: Bond yields increase as interest rates rise, bond prices fall. As such, you can look for a fund that benefits from falling bond prices, such as the ProShares Short 20+ Year Treasury ETF (To be determined).
TBF has crushed the market for the past six months, up 21% against a 15% loss in the S&P 500. (In fact, I recommended buying shares of TBF in my Investment report research service on January 14, 2022, and our position is up 17.50%. You can learn how to access this recommendation and more by click here.)
Although “indirect hedges” such as these do not automatically increase when the set declines, today’s market has demonstrated that they can generate big gains in a turbulent market environment.
And while we wait for the storm to pass, please check tuesday smart moneyin which I catalog three things you can do now to survive and thrive in the long term.
PS Currently, there are 25 very popular stocks held by millions of Americans. These things are ticking time bombs. Please: make sure you do NOT own these companies now and do not buy them in the future, even if they are cheap. Details here.