Risk reduction is important no matter your investing time frame, says Mark Wolfinger, who explains the optimal strategy for the long-term investor.
Why should long-term investors hedge? We're with Mark Wolfinger, who is going to explain that to us.
An investor should hedge basically to reduce risk. Hedge is just the term that refers to an investment that is made specifically to offset part or all of the risk of holding another investment. In other words, if you have a portfolio of stock which is completely bullish, you could take some bearish action-it shouldn't be huge bearish action, but that provides some protection.
If the market goes down, that bearish hedge will take care of part of the losses, and so it's done to reduce losses in a bad situation. For example, if you buy put options, which are expensive...but if you buy put options against a portfolio of long stock, if the market really is bad like 2008-2009 or the 1987 October crash, owning puts will cut the pain enormously.
Sure your stocks will go down and you lose money, but that hedge, those puts you earn, will limit the amount of those losses. After a small loss, those puts will kick in and start to earn money themselves canceling part of the loss.
Now if the market rallies, then you've hedged your upside as well. What that means is your profits will be a little less. What you paid for the hedge, well that hedge will eventually become worthless, but it would have served as an insurance policy. So by hedging you're actually insuring your portfolio the same way you currently insure your house or your car or your life. A hedge is an investment that reduces risk.
And I've heard that that's one of the things that people don't really see. They buy their stocks, they put them in a 401(k) or an IRA, and they just assume that because they want more money later that what they need to do is just stick to those stocks that are long. And they forget about a position that protects them in case the market goes down, which we saw in 2008 when a lot of people lost 50% or more of the value of their stocks because they didn't really have any downside hedge in place.
One question I have for you, using options, if I were to want to hedge my portfolio as a retirement portfolio, how far should I look out, and what percentage of a hedge should I put on my investment?
I'd like to give you a specific answer to that, but the truth is it's really up to you as to how much you want to protect. You can hedge everything. You can make sure that your entire portfolio is protected, so that it has a floor, a value below which it can't go. Now that's expensive. Or you could try to hedge only 80% or 70% or 50% of your assets.
Another way to go is to get complete protection, but maybe you're willing to take a bigger loss. Maybe you are willing to lose 20% of the value in a worst-case scenario, so you can buy protection that's down 20%, sort of a deductible like an insurance policy. I would normally recommend 5% to 10% as a hedge, but that's not a really big loss and that's expensive to protect that.
So if you're willing to have a bigger deductible, you can go out to 20%, even 30%...but obviously there's a point at which it's too far. There's no sense protecting yourself from losing more than 80% of your money. Once you've lost 80%, you're essentially in bad shape anyway, so there has to be a limit. I would say 10% to 20%, depending on how much money you're willing to invest.
In addition to buying puts, you could trade a collar. What a collar is, is you buy that put that protects you, that gives you the right to sell stock at a predetermined price, and you can offset that by selling a call option and that gives someone else the right to buy your stock at a predetermined price.
So if the stock rallies, your gains are limited because someone will choose to buy your stock at the strike price, the predetermined price. However, by selling the call, you get to pay for all or almost all of that put, giving you the hedge for very little if any cash out of pocket, and that's very attractive. The cost is limiting your upside.
Now I think this is something that mom and pop investors all over the country, all over the world, should be doing, instead of just owning stock. They should hedge some or all of it, just to protect against disaster.