Our Insights

About personal finance, investments and markets.
July 5, 2017

To hedge or not to hedge

Volatility. Investors hate it. Any downturn in stocks creates fear for even the most experienced investor. Thankfully it is possible to hedge your portfolio! The financial industry is well aware of investors’ fear of wild gyrations. It offers many products and strategies that promise to keep volatility in check. But the more important question is “should you hedge”? We think long-term investors should avoid the siren songs of the financial industry for mainly three reasons:

1. Nobody has a crystal ball

It is understandable that you might want to hedge yourself against a market crash. Who wouldn’t? But this implies that you somehow know when the next crash is going to happen. Sadly nobody has a crystal ball. Not even the stock market gurus that constantly appear on the financial media. Btw, why is the media using the word ‘guru’? Probably only because ‘charlatan’ is too long to fit into a headline…

Let’s just take a look at some of the gurus‘ predictions and judge for yourself:

guru5

2. Hedging costs money

Everybody has probably heard by now that we are in a low-return environment. With interest rates around zero and 10 year German government bonds yielding only 0,4% it is painfully clear that we cannot project high historical returns forward. Controling costs is therefore extremely important. But hedging costs money and thus eats into your returns.

Example: the historical 20 year annual return of the German stock index DAX is 7%. To hedge your portfolio against a total loss for the next 12 months with put options costs about 8% currently. It is evidently clear that this doesn’t make much sense as an ongoing strategy.

3. Hedging goes to the heart of what investing is NOT about

Here is the key question: do you want to maximize return or minimize volatility? Academic studies show that both is not possible. Investors need to decide… But do they really? We would question that this even a choice for long-term investors. We would argue that volatility is not a useful parameter for financial planning. After all, high or low volatility doesn’t buy you anything.

The real risk for investors is permanent loss of capital. But this is very different from volatility (=temporary loss of capital). Volatility is therefore an extremely poor measure of risk! Permanent loss of capital however can be easily managed with a broadly diversified portfolio.

In the end, investing is a behavioral problem more than anything else. The best investment strategy is of no use if we are prone to panic at the wrong time. If the volatility in your portfolio is too high then the right way forward is not to engage in some complicated hedging strategies but to adjust your equity/bond mix to a more reasonable level while markets are still calm.

Real world test: Make volatility your friend, not your enemy!

Imagine you have two investment options:

Investment #1: you put $1,000 into an investment every month for 20 years, with the possibility of seeing that investment getting cut in half twice.

Investment #2: you put $1,000 into an investment every month for 20 years, with the same annual performance as investment #1 but suffer no drawdowns.

Which would you choose?

Most investors would pick option #2.

But this is the wrong choice if you are trying to maximize your long-term gains. The key point here is to remember that you are putting aside $1,000 EVERY month. Even when the market crashes 50%. Then you actually get twice as much for your money! Of course option #2 is easier to live with. But in the more volatile option #1, you take systematically advantage of the declines.

Learn to embrace volatility, not fear it. We know this is difficult, but we can help you put together the right financial plan and stay the course during those difficult times. Conditioning yourself to love drawdowns is not easy but it is easier if you work together with a trusted partner.

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