Sunday, September 9, 2018

Does Your Equity Portfolio Needs Hedging?

I received an email from an avid reader who is genuinely concerned if the next recession will put a dent on her portfolio which she has been building for years.

She asked if it's necessary to put a hedging instrument in the portfolio in order to minimize the downside risk of her portfolio given that they are mostly in traditional equities and the nature as such that she is worried her net equity portfolio will go down once recession hits.

While she didn't specify her age, it appears that she is in the 30s range.

It is always difficult to give a guidance advise in this sort of scenario as everyone's risk profiles are different hence the tolerance level would also deviate.

Investing itself involves risk and in order to generate a good amount of returns over time, it is inevitable that we have to take intelligent risk and this includes the risk in our traditional equity portfolio.

Getting An Instrument Hedging in Your Portfolio

This is the most straightforward nature of hedging one's portfolio.

If most of your portfolio consists of equities, then to reduce the correlation you'd have to include asset classes which has a natural hedging character opposite to it.

One example is Gold.

Kevin from Financial Horse wrote a good article on Gold recently which explains how they fare in the long term. The key idea takeaway from the article is that gold outperforms all the other assets when there are big risk volatility movement in the economy when there are recession or threats that try to destroy the economy but in all other scenario, they are mostly underperforming. 

Do note however that while you are in a way reducing the correlation of your portfolio through investing in gold, you are restricting the returns which equities can give you over the long run too.

The other example is buying a put option, which includes adding a derivative nature to it.

Technically, a stock that you own can go down in value and in the most unlikely scenario it can even go down to zero. That rarely happens to solid strong companies but we've seen some example happening to some companies with weaker financial health.

Buying put options lets you determine how much risk of loss that you're willing to endure.

A put option gives you the flexibility to sell the shares at a pre-determined price until the expiration date. You do have to pay a premium to buy that option but it gives you a flexibility to exercise them should you wish to.

Rebalancing Portfolio Allocation Naturally

This is a much easier way to "hedge" your portfolio and is also my personal preference.

Generally, my preference in the portfolio is to include equities and cash with the latter being the option that I can utilize from when I want to add more equities.

When the economy is undergoing a trough, there are usually plenty of options to buy great companies at a decent valuation and that is where the cash is being utilized to add more equities to the portfolio.

When the economy is at the peak, then the portfolio allocation will tweak to the opposite side, since we'd be selling equities with high valuation and going more into cash.

The permanent portfolio advocates including bonds and gold into this method, on top of equities and cash, but I think an allocation of equities and cash are good enough to demonstrate the natural hedging ability.

Invest in Proper Due Diligence with Margin of Safety

This is perhaps the most underrated way of "hedging" but all investors should properly do his or her own due diligence and only invests in companies with good financial standings and a margin of safety.

With the criterias in place, there is even little need to do the traditional hedging because the companies you buy will always do fine in a poor economic scenario and will be able to bounce back once the economy recovers.

Hence, your worry is very much reduced as compared to someone who chase after companies that are "hot" in the market but provides very little value in reality.

Adding Salary As Your Additional Capital Allocation

If you are someone who has a sound job and has been consistently adding part of your savings as additional capital allocation to the portfolio, then the amount of cash you're going to put in will act as a buffer and natural hedging in the form of additional capital cash allocation.

Most of the idea of hedging is to be able to survive the downside scenario and if we can exercise all of this prudently and accept that recession is just a part and parcel of our lives, then we'd be able to thrive when the economy recovers. In fact, most rich people actually thrives the most during recession because they are able to take advantage while the retail investors usually go into hiding.

Thanks for reading.

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  1. The question to ask ourselves: Do we need to liquidate some stocks in our portfolio of equities to meet or supplement household expenses or some expected expenses in the near future?

    Volatility in the stock market may not be permanent losses. Not same!

    1. Hi Uncle CW

      I think it's bad planning if we have to liquidate some of the stocks in our portfolio to meet the day to day needs of the expenses.

      That one is basic fundamental issues in the first place.

  2. Stress test: 50% stock market decline, 3-year economic slump, lose job, jobless for 1 year, finally get a job at 1/2 of last salary.

    Can you & your family get by without being forced to sell your holdings at depressed prices?

    How much dividends do your portfolio generate? Did the underlying companies cut their dividends during GFC? Admittedly not many local companies are dividend aristocrats that are able to increase dividends even during recessions.

    Being forced to sell your stocks at low prices is wealth destruction. It means being too extended in risk assets & not enough safety buffers to be anti-fragile.

    Easiest is simply to limit the amount of risk assets e.g. 50% or 60% or 70% stocks, and the rest in cash or govt bonds.

    1. Hi Anonymous

      Stress test is a good way to gauge our emotional and financial level. We can easily use the GFC as a test to see how we would react in that circumstance.

      If we are young, it'll be a good moment to keep on adding and when market rebounds we can cash out to put them into lower volatility assets as we age older.

  3. Gold is not for me either. Buy when Mr. Market has a bad day and get some value. Don't bet on the zombie apocalypse.

    1. Hi SDC

      Looks like we are in the same no gold camp for now :)

  4. Very good advise. At this level of correction, if one is already having sleepless nights, it is an indication that you do not have a backup plan. Theory is not same as one who goes thru the cycle personally.

    1. Thanks Anonymous.

      Agreed, the best plan to have is to know what to action when outcome comes our way.

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