Friday File Part One: Hedging

Outlining my new (simple and limited) hedging strategy

By Travis Johnson, Stock Gumshoe, January 26, 2018

I’m separating my comments here about hedging out from the rest of my ongoing Annual Review commentary, just for the sake of clarity (the latest missive, on my natural resources-related holdings, is here).

I’ve written about hedging before — it tends to be expensive, if it’s effective at all, and it needs to be thoroughly thought through before you commit cash to a hedging strategy. First you have to know how much of a loss you can tolerate, whether you’re hedging against catastrophe or just trying to predict short-term gains and avoid any losses, and whether you want to spend a little to hedge against something terrible happening really soon, or spend more to hedge against something terrible happening over the next nine months, or next two years, or whatever.

So knowing yourself is a key. Personally, I can live with a 20% decline in stocks and, in many of my portfolio positions, would consider that a great buying opportunity. I’m not yet 50 years old, and will be working for quite some time so I have the opportunity to make up losses to some degree, but if there’s a non-trivial chance that the market could fall by 50% again and take longer than a year or two to recover from that fall, then I want to be protected.

One way to protect yourself from that, of course, is by simply putting a 20% stop loss on all of your positions — automatically selling everything if the market is crashing to that extent. That works, as do most stop losses in that 15-25% range, and it will protect you if there happens to be an ugly 30% or 50% drop in the market. But the question that stymies most investors is when will you buy back in?

For my broader market exposure, I want to be invested through the next crash and the next recovery — I may change the stocks I own, stop out of some and buy others, but I don’t want to effectively sell out of my whole portfolio and bet that I’ll know the right day on which to buy back in. I won’t know, that’s the absolute hardest thing about market timing… selling to stop your losses works well at stopping your losses, but if you stay sold and don’t buy back in somewhere as the market bottoms, wherever that is, the ...

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