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How the Market Works

How the Market Works & Why You Care:  Hedge Your Bets

Posted by kdadmin on October 23rd, 2015.

How the Market Works & Why You Care:  Hedge Your Bets

We’ve all heard phrases like, “Hedge Your Bets,” or “Don’t Put All Your Eggs In One Basket,” etc. The chart above is what this looks like when it comes to investments. One month ago, I bought IJH (a midcap stock ETF) to hedge against a potential unexpected move inAGG (one of our bond positions). Now why would I do this? Moreover, given IJH’s volatility, and under performance, why would I tell you?

Actually, it’s pretty straightforward …

A little bit over a month ago, I bought heavily into the bond market (at the time, the stock market was at a recent high, and bonds looked good, sound familiar?) but I wasn’t convinced that the stock market rally would last. Since the Fed didn’t raise their rates, bonds were likely to do better than stocks over the next bit. HOWEVER, just because I thought I was right, and just because my very expensive research said I was right, I wasn’t willing to bet all of my clients’ money on this conclusion. So, I took a small bit of money and hedged it into IJH to cover my clients’ butts on the off chance the stock market rally surprise continued. If you look at the chart above, you can see that there was no stock market surprise.

Now, here comes the interesting part, by using MATH, correlation coefficients and standard deviations, I was able to figure out how tiny a piece of IJH I needed to buy; in comparison to my larger bond stake, to balance off the risk. It was roughly only about 8% of the entire portfolio. So, given the historical volatility of AGG and of IJH, I was able to drastically reduce the risk of a large bond portfolio investment in my clients’ accounts, with a tiny hedge, and carry them through volatile economic times. Further, as time went on, the hedge was not large enough to torpedo the clients’ returns over the period.

One caveat, IF a client had a portfolio, like a 401k, held at a firm with limited investment options that DID NOT allow me to properly diversify taking a large stake in a bond portfolio, because I had no investment option to diversify against such a risk, I would not have made the bond investment. There would have been no way to protect that client in the event that the stock market rally surprise continued.

I tell you all this to illustrate five fundamental investing concepts:

  1. Proper investment hedging is HARD to implement. It takes math, and a thorough understanding of advanced economic topics. Moreover, you have to know when the short term risk has likely passed and it’s time to sell your hedge.
  2. But, it IS POSSIBLE to properly diversify a portfolio to cover your butt in volatile times.
  3. Just putting some money in stocks and some money in bonds doesn’t cut it. Sometimes, the answer is “neither,” or “both,” or “42,” if you’re reading The Hitchhiker’s Guide to the Galaxy.
  4. Post modern portfolio theory dictates that clients prefer unexpected gains to unexpected losses. While this seems obvious, it’s NOT an obvious assumption in statistical analysis, which is what most investment allocation theory is built upon.
  5. Nobody can predict the future. But we can certainly PREPARE for it.

So, we’re back to Why You Care. Well, the stock market is back to where it was just over a month ago. In fact, it’s a bit higher; in spite of the fact that there is nothing, really, holding it up. PE ratios are still too high, and earnings numbers have generally sucked. We are seriously flirting with deflation, a strong dollar is messing up our balance of trade, yet low oil prices, nearly full employment and a SUPER liquid economy can’t seem to spur our GDP number to where they need to be. Not to mention, consensus estimates show us at over a 4% loss for the year. We’re not in Kansas anymore, Dorothy.

In other words, YOU CARE because if you have some favorite stocks you’ve been holding onto, you may have been given an opportunity to cut them loose, or set your stop losses closer to their current prices. After all, for all its sound and fury, the stock market has gone exactly nowhere this entire year. Yet, it’s still possible to make money, if you know what you’re doing …


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