Hedging can end your retirement panic now

August 22, 2011

Even with the most recent market agita, there’s no reason for you to worry long-term about your retirement funds.

Is my head in the clouds? As darkly volatile as this moment in personal investing may seem, it’s actually a golden age for portfolio insurance. Retirement worries as we know it can come to an end — if you know how to hedge properly. There are plenty of retail tools available to that end.

Part of my optimism is based on the availability of off-the-shelf portfolio insurance for everyone. If you hedge your holdings the way the big institutions do, big dips will do no harm and you can even make money when the market’s down.

The three most powerful hedging devices come in the form of exchange-traded funds (ETF), which are pooled portfolios based on securities and indexes traded on stock exchanges. You can buy them from any deep-discount broker and leave them in place.

Hedge inflation
A rising cost of living generally hurts bond prices. Unlike most bonds, when inflation climbs, Treasury Inflation-Protected Securities gain value. One suggestion is the iShares Barclays TIPS bond fund.

Hedge your stocks
Inverse ETFs such as the ProShares Short S&P 500 ETF, move in the opposite direction of the popular stock index.

Hedge your bond position
You can short a broad-market bond index through the Direxion Daily Total Bond Market Bear 1X Share or similar ETFs. This is a good hedge if your portfolio is heavy in bonds and interest rates are rising.

I won’t stop here, because you can also hedge positions in countries, commercial real estate, metals, currencies, individual stocks and industry sectors.

You can even double and triple your returns with “ultra-short” ETFs. And if you want to write options contracts — wagers that a security or index will rise or fall — you can do that, too.

Of course, all hedging strategies require full knowledge of the benefits, risks and pitfalls. They get complicated. There is always risk involved and you can lose money. If you’re not comfortable with doing it yourself, seek the services of fiduciary adviser such as a registered investment adviser or certified financial planner.

When might you best use portfolio insurance? Say you have a large holding in one stock such as your employer. Or you want to stay in stocks for the growth, yet hate the market risk. Or you’re mostly in bonds and worry about inflation. There is now a hedge for nearly everything and a way to insure against loss.

Think you’re going to live long? You can buy longevity insurance so that you don’t outlive your money. Not that optimistic about your life span? There’s always life insurance, although if you’re not healthy, you smoke or work in a dangerous occupation, you’ll pay dearly for it.

If the insurance/hedging route doesn’t work for you, there’s another way of keeping the beast of fearful decisions at bay: Set up a portfolio that won’t keep you up at night.

One of the least-heralded — and simplest — ways to avoid the stomach-wrenching decision-making during a market dip is to stay the course with a sensible, risk-adjusted portfolio. If you have the allocation that’s right for you — that is, the amount of stocks, bonds and alternatives you are most comfortable with given your age, lifestyle and vocation — then stay put and keep contributing to your retirement kitty.

Those who stayed the course from the grim days of October 1, 2008 through June 30, 2011, saw their 401(k) account balances grow by 64 percent through that period, according to a new study by Fidelity Investments.

Wait, this can’t be right. Wasn’t the time right after the meltdown a bad time to be in stocks? Weren’t you better off retreating to cash?

Fidelity found that those who pulled out of stocks entirely — re-entering in July of this year — only saw their balances grow two percent.  Those who kept investing not only caught a rebound, but bought at rock-bottom prices.

No matter what route you choose, you need to ask yourself the question: Where I am most exposed to market, credit, country or inflation risk? Once you’ve isolated these potential perils, hedge them. Then do something even more sensible — enjoy the rest of the summer.

14 comments

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I think a great article to read relating to the above is “…A Value Investor’s Perspective on Tail Risk Protection: An Ode to the Joy of Cash…” by GMO’s James Montier. Long story short – unless you have a very good idea of the timing of an event and exactly what risk you want to hedge out of time cash is a great way to ride out risk.

Posted by Sicklyafrican | Report as abusive

I’m always more than a little concerned about what “riding out” means, because it implies that the person retreating to cash knows the best time “to ride back in.” Most people guess wrong and miss major rallies, so it’s best to have a consistent risk-adjusted plan that’s not dependent upon timing the market.

Posted by johnwasik | Report as abusive

Your opinions are a disservice to your Readers;
in particular your comment about hedging using Inverse ETFs

The SEC has issued an ALERT “Leveraged and Inverse ETFs: Specialized Products with Extra Risks for Buy-and-Hold Investors” – Source: http://www.sec.gov/investor/pubs/leverag edetfs-alert.htm

Specifically the SEC states “Leveraged and inverse ETFs typically are designed to achieve their stated performance objectives on a daily basis. Some investors might invest in these ETFs with the expectation that the ETFs may meet their stated daily performance objectives over the long term as well. Investors should be aware that performance of these ETFs over a period longer than one day can differ significantly from their stated daily performance objectives.”

I have seen the long term results inverse ETFs in action; The losses can be huge and in MY OPINION inverse ETFs should be banned; they serve no economic purpose. The SEC is correct about the risks. An ethical fiduciary advisor would, under no circumstances, recommend an inverse ETF.

Mr. Wasik, please do your homework, before expressing your opinion in a national medium. A correction would not be out of order.

Posted by Restless | Report as abusive

SCARE 20.12.2012
(Stop Corruption and Repression Effective 20.12.2012)
Banks were given a very important privilege to create more in the form of extending credit. This function requires diligence and careful consideration in regard to individual credit risks as well as to overall credit levels in the system. The financial crisis revealed that the banks were operating at too high a leverage and with too much risk. They were used to be saved by the Central Banks and certain that in times of difficulties the Central Banks were there to save them. They were like trained dogs and their master Greenspan or Bernanke would always be there to rescue them when unforeseen difficulties arose.
That may be true but that does not absolve them from their obligation to monitor overall debt levels in the system as well as being diligent in evaluating the debtors ability to not only service a debt but to be able to repay it over time. The banks clearly failed in this function that is the core function of banking but focused mainly on their compensation packages. The way these bankers enriched themselves in the process of driving the financial system into a wall was appalling and the average income earner was never able to comprehend their schemes but preferred to simply ignore them. Of course, the bankers explained their outrages income levels with free market principles of supply and demand, where the best simply could be hired with those kinds of benefits only. In hindsight those superior managers seem to have missed their mark considerably. The most interesting aspect of all of this is the fact that, after we have been more than 3 years in this financial crisis, the bankers continue to loot the system as if nothing ever happened.
True to form the Central Banks “saved” the financial system by saving those great financial institutions without whom the system would have collapsed, as was argued. Hardly were we out of the danger of collapse, the banks immediately went back to their old ways and were certain that this was a problem that would occur just once in a lifetime and now all was clear again. The real problem, however, had not been addressed but had simply been muddied.
In actuality, the losses produced of extending unsustainable levels of credit by the banks have been transferred to the public. Different ways were chosen to achieve this task in the form of free money for the banks, injection of government funds into some institutions, increase of basic money supply and so on.
The threat of system collapse would have been labelled blackmail if it would have occurred in another setting. However the bankers were able to influence the media, the legislators and regulators in their favour with all the financial resources available to them. Nobody was made to take any responsibility and no one was taken to account.
This represents a serious violation of the spirit of the Rule of Law that is the basis of western society. It seems that now the new rule is Might is Right. This changes many parameters in the compass of the social system within the western world. No one can be sure on what level and when one will be subjected to the financial abuse of those elites. Presently, the people in charge are trying to enhance financial repression of which one form is to keep interest rates below the level of inflation which affects mainly those that lived within their means over the past many years; another clear violation of the spirit of the Rule of Law as it transfers losses from bad investments to the innocent and decent part of the population. In addition, the increased level of government debt puts in doubt all those benefits promised by governments the world over.
It is interesting how the banks were able to confuse the public that they are unable to grasp the actual situation. But considering their great financial resources, it seems not that much of a miracle to influence the media and the legislator and having politicians do their bidding. The question is what the heck can WE, THE PEOPLE do about it.
Usually, we could address such things on a political level as we are a democracy, right? But it seems that the system has been corrupted by all the money sloshing around and it is extremely difficult to find any electable person that will act against those powerful interests. In addition, it will take many years until sufficient numbers of persons with the new thinking and with integrity not to be corrupted by those lobbying efforts will be elected to office that will implement the changes needed. So, what should we do? Start a revolution?
Well, the blackmail used by the banks may be the only way to address the injustices that have occurred over the past few years. They showed us how to leverage one’s limited resources to achieve one’s goal. Therefore the following proposal to start the movement “SCARE 20.12.2012” should be seen in this context. The idea is that if by that time (20.12.2012) some serious injustices have been removed from the system, people start to withdraw their money from all financial institutions driving them into default. And it might work, because those who hesitate to support this threat may be left with no money as the banks will have to close down before all has been paid out.
Now, what demands are made if that scenario is to be avoided.
1. Bankers and past Bankers (all those working in the financial industry that earned in excess of $500k plus annually for more than 2 years during the past 15 years and this without any downside risk i.e. risk of financial losses, except the possibility of losing their job) have to be made personally accountable for their past activities and be removed from any such position that might directly or indirectly have influence on the money creation and lending aspects of the economy (this includes regulating agencies and politics) before 20.12.2012.
2. Present and past regulators have to be made personally accountable for their past activities and be removed from any such position that might directly or indirectly have influence on the money creation and lending aspects of the economy (this includes financial institutions and politics) before 20.12.2012.
3. Politicians that accept any financial support from institutions that are involved in the money creation and lending aspects of the economy will have to face a jail term of no less than 2 years without the possibility of parole.
When these 3 points are implemented before 20.12.2012, we the public will not destroy the financial system but support the way to find back to the RULE OF LAW and away from the idea of MIGHT IS RIGHT.

Posted by linushuber | Report as abusive

FYI

direxion daily is not an instrument for long term hedging. it replicates underlying index on daily basis and in long period it’s performance can significantly differ from the performance of underlying index.

Posted by Yeghishe | Report as abusive

So the advise is to buy funds that short the markets to hedge the funds you own that are long in the markets? Why not just stay out of the markets, not pay the fees, and just stay in cash? Maybe because then nobody will be able to collect those fees?

Posted by CashIsKing | Report as abusive

Look, I know inverse ETFs can be trouble because I wrote about specific risks a few weeks ago. So BE CAREFUL with them if you decide to use them as hedges. They are not perfect hedge vehicles and there are many things you need to know about them. As I stated in the piece, you would be well served to employ a fiduciary advisor if you’re going to use them at all. Don’t try to speculate or time the market. You will get burned. My main point is to use all the tools at your disposal if your allocation is exposed to any kind of extreme risk. Know what’s involved in making your allocation less risky. Work with financial planners if you can pay them on a fee-only basis. Get help. This stuff is not foolproof and fools will get into trouble!

Posted by johnwasik | Report as abusive

John, thank you for the finest article (seen here) lately addressing the angst of the averaged. What fee schedule would I expect for your weekly fiduciary advise? jk..

Posted by pHenry | Report as abusive

If the economy is growing at 5% then good investments net 7-8 and bad investments invest 2-3. If the economy is growing at less than 2%, and you have inflation then there is simply no way for the public to invest well. Sure you can always find ways to make money in a down market but no matter how you cut it – most people are screwed.

Posted by John2244 | Report as abusive

Buy and Hold is a better methodology than trying to time markets using hedges. Most people aren’t that sophisticated.

Posted by Viaphacops | Report as abusive

The reason we have a need to hedge is that the institutions purported to provide for the bulk of our retirement needs, Social Security and Medicare, have failed us. They have been labelled Ponzi schemes and frauds by the institutions who are supposed to pay the obligations and it is clear those institutions, which are all parts of the US Federal Government will not pay. In addition, the American financial industry has defrauded the public with derivatives, which as “hocus pocus” just trust us securities. You recommend new, improved products from the identical folks.

Why should we trust institutions that have lied to us and taken our money under false pretenses so long? If they were reliable, we would not be in a panic in the first place. The logic seems to be that just because the first products we were sold were frauds, why not by more from the same people? Might get lucky next time around. Humbug!

Posted by txgadfly | Report as abusive

SCARE 20.12.2012
(Stop Corruption and Repression Effective 20.12.2012)

Banks were given a very important privilege to create money in the form of extending credit. This function requires diligence and careful consideration in regard to individual credit risks as well as to overall credit levels in the system. The financial crisis revealed that the banks were operating at too high a leverage and with too much risk. They were used to be saved by the Central Banks and certain that in times of difficulties the Central Banks were there to save them. They were like trained dogs and their master Greenspan or Bernanke would always be there to rescue them when unforeseen difficulties arose.
That may be true but that does not absolve them from their obligation to monitor overall debt levels in the system as well as being diligent in evaluating the debtors ability to not only service a debt but to be able to repay it over time. The banks clearly failed in this function that is the core function of banking but focused mainly on their compensation packages. The way these bankers enriched themselves in the process of driving the financial system into a wall was appalling and the average income earner was never able to comprehend their schemes but preferred to simply ignore them. Of course, the bankers explained their outrages income levels with free market principles of supply and demand, where the best simply could be hired with those kinds of benefits only. In hindsight those superior managers seem to have missed their mark considerably. The most interesting aspect of all of this is the fact that, after we have been more than 3 years in this financial crisis, the bankers continue to loot the system as if nothing ever happened.
True to form the Central Banks “saved” the financial system by saving those great financial institutions without whom the system would have collapsed, as was argued. Hardly were we out of the danger of collapse, the banks immediately went back to their old ways and were certain that this was a problem that would occur just once in a lifetime and now all was clear again. The real problem, however, had not been addressed but had simply been muddied.
In actuality, the losses produced of extending unsustainable levels of credit by the banks have been transferred to the public. Different ways were chosen to achieve this task in the form of free money for the banks, injection of government funds into some institutions, increase of basic money supply and so on.
The threat of system collapse would have been labelled blackmail if it would have occurred in another setting. However the bankers were able to influence the media, the legislators and regulators in their favour with all the financial resources available to them. Nobody was made to take any responsibility and no one was taken to account.
This represents a serious violation of the spirit of the Rule of Law that is the basis of western society. It seems that now the new rule is Might is Right. This changes many parameters in the compass of the social system within the western world. No one can be sure on what level and when one will be subjected to the financial abuse of those elites. Presently, the people in charge are trying to enhance financial repression of which one form is to keep interest rates below the level of inflation which affects mainly those that lived within their means over the past many years; another clear violation of the spirit of the Rule of Law as it transfers losses from bad investments to the innocent and decent part of the population. In addition, the increased level of government debt puts in doubt all those benefits promised by governments the world over.
It is interesting how the banks were able to confuse the public that they are unable to grasp the actual situation. But considering their great financial resources, it seems not that much of a miracle to influence the media and the legislator and having politicians do their bidding. The question is what the heck can WE, THE PEOPLE do about it.
Usually, we could address such things on a political level as we are a democracy, right? But it seems that the system has been corrupted by all the money sloshing around and it is extremely difficult to find any electable person that will act against those powerful interests. In addition, it will take many years until sufficient numbers of persons with the new thinking and with integrity not to be corrupted by those lobbying efforts will be elected to office that will implement the changes needed. So, what should we do? Start a revolution?
Well, the blackmail used by the banks may be the only way to address the injustices that have occurred over the past few years. They showed us how to leverage one’s limited resources to achieve one’s goal. Therefore the following proposal to start the movement “SCARE 20.12.2012” should be seen in this context. The idea is that if by that time (20.12.2012) some serious injustices have been removed from the system, people start to withdraw their money from all financial institutions driving them into default. And it might work, because those who hesitate to support this threat may be left with no money as the banks will have to close down before all has been paid out.
Now, what demands are made if that scenario is to be avoided.

1. Bankers and past Bankers (all those working in the financial industry that earned in excess of $500k plus annually for more than 2 years during the past 15 years and this without any downside risk i.e. risk of financial losses, except the possibility of losing their job) have to be made personally accountable for their past activities and be removed from any such position that might directly or indirectly have influence on the money creation and lending aspects of the economy (this includes regulating agencies and politics) before 20.12.2012.
2. Present and past regulators have to be made personally accountable for their past activities and be removed from any such position that might directly or indirectly have influence on the money creation and lending aspects of the economy (this includes financial institutions and politics) before 20.12.2012.
3. Politicians that accept any financial support from institutions that are involved in the money creation and lending aspects of the economy will have to face a jail term of no less than 2 years without the possibility of parole.

When these 3 points are implemented before 20.12.2012, we the public will not destroy the financial system but support the way to find back to the RULE OF LAW and away from the idea of MIGHT IS RIGHT.

Posted by linushuber | Report as abusive

SCARE 20.12.2012
(Stop Corruption and Repression Effective 20.12.2012)

Banks were given a very important privilege to create money in the form of extending credit. This function requires diligence and careful consideration in regard to individual credit risks as well as to overall credit levels in the system. The financial crisis revealed that the banks were operating at too high a leverage and with too much risk. They were used to be saved by the Central Banks and certain that in times of difficulties the Central Banks were there to save them. They were like trained dogs and their master Greenspan or Bernanke would always be there to rescue them when unforeseen difficulties arose.
That may be true but that does not absolve them from their obligation to monitor overall debt levels in the system as well as being diligent in evaluating the debtors ability to not only service a debt but to be able to repay it over time. The banks clearly failed in this function that is the core function of banking but focused mainly on their compensation packages. The way these bankers enriched themselves in the process of driving the financial system into a wall was appalling and the average income earner was never able to comprehend their schemes but preferred to simply ignore them. Of course, the bankers explained their outrages income levels with free market principles of supply and demand, where the best simply could be hired with those kinds of benefits only. In hindsight those superior managers seem to have missed their mark considerably. The most interesting aspect of all of this is the fact that, after we have been more than 3 years in this financial crisis, the bankers continue to loot the system as if nothing ever happened.
True to form the Central Banks “saved” the financial system by saving those great financial institutions without whom the system would have collapsed, as was argued. Hardly were we out of the danger of collapse, the banks immediately went back to their old ways and were certain that this was a problem that would occur just once in a lifetime and now all was clear again. The real problem, however, had not been addressed but had simply been muddied.
In actuality, the losses produced of extending unsustainable levels of credit by the banks have been transferred to the public. Different ways were chosen to achieve this task in the form of free money for the banks, injection of government funds into some institutions, increase of basic money supply and so on.
The threat of system collapse would have been labelled blackmail if it would have occurred in another setting. However the bankers were able to influence the media, the legislators and regulators in their favour with all the financial resources available to them. Nobody was made to take any responsibility and no one was taken to account.
This represents a serious violation of the spirit of the Rule of Law that is the basis of western society. It seems that now the new rule is Might is Right. This changes many parameters in the compass of the social system within the western world. No one can be sure on what level and when one will be subjected to the financial abuse of those elites. Presently, the people in charge are trying to enhance financial repression of which one form is to keep interest rates below the level of inflation which affects mainly those that lived within their means over the past many years; another clear violation of the spirit of the Rule of Law as it transfers losses from bad investments to the innocent and decent part of the population. In addition, the increased level of government debt puts in doubt all those benefits promised by governments the world over.
It is interesting how the banks were able to confuse the public who was/is unable to grasp the actual situation. But considering the banker’s great financial resources, it seems not that much of a miracle to influence the media and the legislator and having politicians do their bidding. The question is what the heck can WE, THE PEOPLE do about it.
Usually, we could address such things on a political level as we are a democracy, right? But it seems that the system has been corrupted by all the money sloshing around and it is extremely difficult to find any electable person that will act against those powerful interests. In addition, it will take many years until sufficient numbers of persons with the new thinking and with integrity not to be corrupted by those lobbying efforts will be elected to office that will implement the changes needed. So, what should we do? Start a revolution?
Well, the blackmail used by the banks may be the only way to address the injustices that have occurred over the past few years. They showed us how to leverage one’s limited resources to achieve one’s goal. Therefore the following proposal to start the movement “SCARE 20.12.2012” should be seen in this context. The idea is that if by that time (20.12.2012) some serious injustices have not been removed from the system, people will start to withdraw their money from all financial institutions driving them into default. And it might work, because those who hesitate to support this threat may be left with no money as the banks will have to close down before all has been paid out.
Now, what demands are made if that scenario is to be avoided.

1. Bankers and past Bankers (all those working in the financial industry that earned in excess of $500k plus annually for more than 2 years during the past 15 years and this without any downside risk i.e. risk of financial losses, except the possibility of losing their job) have to be made personally accountable for their past activities and be removed from any such position that might directly or indirectly have influence on the money creation and lending aspects of the economy (this includes regulating agencies and politics) before 20.12.2012.
2. Present and past regulators have to be made personally accountable for their past activities and be removed from any such position that might directly or indirectly have influence on the money creation and lending aspects of the economy (this includes financial institutions and politics) before 20.12.2012.
3. Politicians that accept any financial support from institutions that are involved in the money creation and lending aspects of the economy will have to face a jail term of no less than 2 years without the possibility of parole.

When these 3 points are implemented before 20.12.2012, we the public will not destroy the financial system but support the way to find back to the RULE OF LAW and away from the idea of MIGHT IS RIGHT.

Posted by linushuber | Report as abusive

I agree that hedging opportunistically can make sense for investors, but when it comes to hedging stocks, I think buying optimal puts on individual stocks (to hedge stock-specific risk) or on index ETFs (to hedge market risk) makes more sense than buying inverse ETFs.

One reason is that optimal puts offer more precision. Another is that they give you the ability to cap your cost at the outset. A third reason is that they can be less of a drag on your portfolio during periods when the market goes up. I elaborated on this in a post a while back: http://seekingalpha.com/article/271046-o ptimal-puts-versus-inverse-etfs-for-hedg ing

Posted by Dave_Pinsen | Report as abusive