How To Hedge Your Portfolio
Here’s a short little tip you might find helpful.
The other day I was talking with someone when the conversation finally turned to the familiar, ‘what do I do now’ question.
I told him what he intuitively already knew: No one can predict the future and no one really knows. Asset management isn’t about prognostication, contrary to what you see on the business talk shows; it’s about managing risk. In fact, it’s about managing a list of risks which include market risk, inflation risk, legislative risk (taxes), interest rate risk, currency risk, etc. It’s quite a list.
So, we don’t manage money, we manage risks – We just do it with money.
Today, we have uncertainty in the stock market – That’s a constant. Markets have always been uncertain and they always will be. No sense spending time gnashing our teeth over that one. There’s also a lot of concern about inflation, interest rates, as well as the price of energy due to mid-east uncertainties that seem to have no end.
Let’s move on to how all that uncertainty can be managed.
One way is hedge your portfolio. But how do you do it? It isn’t as difficult as you might think. Recognize that, in the investment world, there are only two things you can do with money: You can use it to own or you can use it to loan. Ownership happens on the equity (stock) side of your portfolio. When you loan your money out, you’re in bonds. You can hedge your bond allocation against inflation risk by using Treasury Inflation Protected Securities (TIPS). You can hedge your equity (stock) allocation against a variety of risks by using real estate and commodities, which include food, energy, and hard assets like precious and strategic metals, etc. All of these hedges can be purchased individually or through a variety of mutual funds, including index funds, and exchange-traded funds (ETFs).
How do you do it?
Take a simple hypothetical allocation of 40% stocks and 60% bonds. If you wanted your portfolio to be 10% hedged, then you would use equity hedges for 4% of your stock allocation and you’d use TIPS for 6% of your bond allocation.
A 20% hedge would look like this: The 40% equity allocation would end-up as 8% in equity hedges and 32% stocks. The 60% bond allocation would end-up as 12% in TIPS and 48% in bonds.
The real question: What size hedge should you have? Ah, that depends on your age, income, outlook, goals, risk assessment, etc. Various hedging ratios will undoubtedly have an impact on portfolio volatility and performance. In order to know IF you should be in a hedged portfolio – and the degree of hedging that would be prudent, you should meet with your advisor – many like myself often conduct online meetings with clients – review your plan, and have your advisor review your portfolio by conducting a portfolio stress-test and compare it to a hedged portfolio. At that point you should be able to make a determination.
Jim Lorenzen is a Certified Financial Planner® and an Accredited Investment Fiduciary® in his 20th year of private practice as Founding Principal of The Independent Financial Group, a fee-only registered investment advisor with clients located in New York, Florida, and California. IFG provides investment and fiduciary consulting to retirement plan sponsors and selected individual investors. Plan sponsors can sign-up for Retirement Plan Insights here. IFG does not sell products, earn commissions, or accept any third-party compensation or incentives of any description. Nothing contained in this material is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment to the individual reader. The general information provided should not be acted upon without obtaining specific legal, tax, and investment advice from an appropriate licensed professional.