Investing in stocks has been rewarding for long-term investors. But that reward comes with risk. If you invest long enough, you are likely to experience a 50% drawdown at some point in your stock portfolio. If you invested in the 2000’s you saw US stocks drop by 43% during the dotcom crash and 50% during the Great Financial Crisis.
It’s no wonder that people are searching for a different way to invest.
In the past, someone who wanted to reduce risk simply added bonds to their portfolio. But as we witnessed in 2022, bonds can be correlated to stocks, especially in inflationary regimes.
Risk management through hedging
A modern approach to investing with less risk involves using hedges. A hedge is a strategy that seeks to limit your risk, just in case a downside scenario occurs. By employing various portfolio hedges, an investor can have a much smoother, less volatile investment experience.
But hedging isn’t unique to investing. A sports bettor can hedge by taking the opposite side of their original bet if the likelihood of their original bet winning has increased. Instead of waiting to see what price they get on the open market after harvest, farmers usually hedge part of their crops by selling in the commodities futures market well before harvest.
Hedging is simply a form of risk management. In any industry where the person or company bears risk, the prudent thing is to seek ways to limit, or hedge, that risk.
How to hedge your portfolio
A common way to hedge the risk of stocks is to use options. Options are contracts that give investors the right to buy or sell an asset at a predetermined price before a predetermined date.
Most people shouldn’t spend the time to buy and sell options themselves. But that doesn’t mean you can’t use them. Innovative investment products that use options to hedge risk are available to use in your portfolio.
Let’s say you want to grow your portfolio but are concerned with having to ride out another stock market drop. It doesn’t typically make sense to sit on the sidelines and wait. Often, you end up getting in after the market has already inflated.
A solution could be investing in a hedged investment product.
A structured note is a financial product that is manufactured by a bank. They track an underlying asset, like the S&P 500, with predetermined levels of downside protection and upside potential.
People buy structured notes mainly for their downside protection. An investor will know at the end of the term (usually between 1 and 5 years) they will be protected against a certain amount of losses if the underlying asset loses value.
Mutual Funds and ETFs
There are an increasing number of investment firms providing “hedged equity” strategies in mutual funds and ETFs. These funds typically track the performance of a stock index and will buy and sell options to provide a level of downside protection.
Many of these funds will have downside protection in the form of a “buffer”. If a fund has a 10% downside buffer, the first 10% of losses will be protected against over the holding period.
Insurance for your investments
Hedging can sound complex, but I would think of it like an insurance policy for your investments. If you own an expensive asset like a house, car, or boat—wouldn’t you want to insure it against fire or an accident?
Hedging has been around for decades, though mainly used by large institutions. Fortunately, we live in a time when these innovative strategies have become more accessible.