The Hierarchy of Hedging

One constant question investors ask when markets are expensive is: how can I protect my capital?

We can protect our capital, but the question depends on your timeframe. So imagine you are 63, then you want a high level of protection if your income is low and you have a nest egg or superannuation to live off. But if you’re young, say, under 40, then the mainstream answer is that you should not worry about it and keep investing. That is not correct and I can show you why. Even if you are young, you should protect your capital from large drawdowns  - what’s a large drawdown? It  depends on the volatility but we can give you a rough idea using standard deviations and showing how the geometric return works). 

The reason to avoid large drawdowns is because they reduces your overall geometric return and this is critical to your long term returns and final wealth. 

Can we suggest that there are ways to actually increase returns during a downturn? No, seriously. 

Many investors abhor cash. They believe that it is better off being deployed at all times which leads to higher returns. This of course fails to acknowledge how markets operate. You must account for volatility.

We know there are cycles and success is a balance between risk and reward. Most investors look at their portfolio incorrectly. You need to broad frame and ignore individual results. 

If you can do this, you see that hedging including holding cash is a net positive if you use cash judiciously by buying during the drawdown and waiting patiently for the rebound. If you had a set amount of cash with no more coming in, I suspect many investors would be more cautious. 

How can you make returns, but at the same time lower risk? 

This is like searching for the holy grail. 

So lay out some ways to reduce the losses from drawdowns and increase your long term returns by mixing your asset allocation, and more generally by adopting a more dynamic approach to asset allocation and rebalancing. We can do some of the following:

1. Reduce our allocations by taking profits and maintaining a lower overall allocation to expensive asset classes.
2. Buy what’s out of favour/cheap - look for where there is value and this can be in countries or sectors or companies within those areas. 
3. Technical Indicators - simple ones like moving averages can provide a signal to lower allocations. 
4. Cash - use it to buy stocks or ETFs when they are cheap and have increased yields. 
5. Inverse ETFs - go short the market. 
6. Inverse Leveraged ETFs - go really short the market:) 
7. Put Options - use strategically for overall protection while maintaining your existing allocation.

Remember timing the market perfectly is nearly impossible so there are a few important points to make. 

1. Get your timeframe and stick to you. Don’t allow the market’s volatility to dictate your strategy as many do. You will only end up angry at chasing returns and failing.
2. Have a systematic approach and don’t wobble when markets wobble. 
3. If you don’t have much experience, don’t try and get rich shorting. Being greedy doesn’t usually help. It just makes you more emotional and prone to errors. 
4. Don’t get complex. Choose one or two strategies at most and stick with them. Make sure you understand them, how they work, and what you are looking to gain from them.

Remember you don’t have to get rich during a big drawdown. You just need to get through it as best as possible and be ready for the next bull market. 

And lastly, allow for a little luck.