How do I hedge my portfolio while still making money on stocks?
Buy and hold use to be the axiom of all of our fathers. Warren Buffet has made himself into one of the greatest investment minds of all time on that trading philosophy as well. It seems as though in modern times this strategy has not produced the types of results we would have expected.
Over the last ten years the S & P 500 index has gone from 1410 down to 1118. This is nearly a 2% annual average decline. You could have been well ahead of the game by simply burying your money or by putting it into certificates of deposit. This certainly doesn’t mean you didn’t have pockets within that time you could have taken advantage. Among the flat returns were definitely times of huge market opportunities. The most important question is how do you participate without getting your head handed to you on a silver platter?
The first key to any investment portfolio is that it contains the proper amount of growth and income to balance out your risk tolerance. This simply means the amount of stocks versus bonds. The trouble in today’s market is that interest rates are going to rise and that is going to hurt the returns you receive on your fixed income portion. Rising interest rates are also difficult on stocks. So what is an investor to do?
If you as an investor are nervous about rising interest rates you could always lock in a fixed rate with another type of vehicle. Fixed annuities as well as CDs will give you locked in rates for given periods of time. The main disadvantage going this route is the fact that if interest rates do rise, you are locked into these investments until the end of the term. This is considered opportunity cost that may backfire on you. You can also do the same things with individual bonds, although outside of treasuries you will take on some credit risk with each bond and in this economy some may not have the stomach.
If you are a strong believer in the markets over the next few years but still wish to alleviate your risk you have other options. If you have a $500k portfolio of stocks you can hedge them by using protective puts. Puts are stock options that protect your stocks at specific levels in the event of falling prices. A simple analogy is that not hedging your portfolio would be the same as a person driving a $100k automobile without any car insurance. It just doesn’t make any sense.
Another hedging strategy one could employ is to short the ETF market. ETFs are exchange traded funds that mimic an index or a particular market sector. By shorting the particular ETF(s) that most correlate to your portfolio you can profit on the downside of the markets, making up for the losses on your stocks.
All in all there is no perfect way to design your portfolio. There are as many ways to construct it as there are stocks in the New York Stock Exchange. The main thing is that you learn the strategies so that you are aware what is available to you. These times are too volatile to simply buy stocks and bury your head in the sand.