The idea behind a hedge is to look to limit the downside in an investment, in other words to decrease one’s risk exposure. As a general rule, and almost by definition, money invested in hedges does not deliver the same upside potential as what it is hedging against, but that is the price you pay for hedging your bets so to speak.
If someone has a significant portion of their investment in the stock market for instance, a major risk is what is called market risk, when the market itself pulls back. When a market goes up, the stock market for instance, this means that more money is being put into the market than is being taken out.
This causes the average stock price to go up, and although this influx of funds doesn’t get evenly distributed, it does affect stock prices generally. We still have to be selective about which stocks we buy, but the chances of making money is increased by the market rising.
Conversely, when there is a pullback in a market, there is a net outflow, people taking more money out of a market than they put in. This reduces the average price for an instrument, a stock for instance.
So, we can make money in a declining market, and of course lose money in an advancing market, depending on the quality of our selections, but when we are trading with the overall market trend, it is simply easier to succeed than when we are trading against the flow.
It doesn’t matter how good you are, as when your positions are not aligned with the overall market trend, it is simply going to be more difficult, and the results you achieve are not going to be as good as when you rode the wave up or down as the case may be.
Long Term Investors Only Swim One Way
Many individual investors do swim both ways so to speak, as well as hedge funds generally, and what separates hedge funds from regular funds is that they have the ability to both go long and short something.
When you can change direction like this, being more long during accumulation periods in the market and more short during periods of decline, there really isn’t the same need to hedge positions by holding investments in other asset classes.
While we still may want to hedge, because hedges still can help us manage our risk exposure, there isn’t the same fundamental need as if you are locked into one direction, the long side, and are looking to simply ride out the storms.
Institutional investors such as mutual funds aren’t generally allowed to go short, and a lot of investors are told that it is pointless to look to either time the market or especially, to look to bet on things going down, shorting, and instead are told that the buy and hold strategy is the only sound way to invest.
In spite of this not being true, it is the case that in some instances, investors may be better off just buying and holding. The main reason actually is that with most investors, the less they trade the better, as trading takes real skill, a lot more than the vast majority of investors realize.
This is not something that rank amateurs with little or no training or experience should take on too much, and the majority of people who look to dabble in trading end up hurting themselves rather than benefiting from the trading versus holding.
Most investment advisors have no clue about how to trade either, or whether this is ever a good idea, so their advice is going to correspond with this lack of understanding, and they are just going to tell people to buy and hold for longer periods.
When the topic of timing markets comes up, they assume that you’re either long or in cash, and it’s actually quite a bit more difficult to beat the market if you’re just doing that, because this requires that you have to time your entries and exits skillfully. If shorting isn’t in your toolkit, and it’s not even in the vocabulary of most market participants, this can make timing things more challenging for sure.
So, for better or worse, and whether ideal or not, a lot of investors are going to be staying long the market and just ride out the waves down.
The Real Purpose of Hedging
If you are going to be holding positions during clear and extended down cycles, where money flows out of the stock market and goes elsewhere, then looking to invest in where the money goes can be an idea well worth considering.
Today’s market environment is a particularly volatile one. Traders love volatility, much like surfers like bigger waves, and traders can ride bigger waves to bigger profits if they are skillful enough to take enough advantage of them.
Long term investors hate volatility, or at least risk, as if there was no volatility then you would never make money, the price would just hang around the same area as preferred shares do.
What these investors really don’t like is major moves against them, even though they may be well within the time frame they are investing. If you are investing for 20 years for instance, and don’t expect to liquidate your positions until at least this long, you should not really be very concerned with things like the recession of 2007, or any event which is not expected to last anywhere near as long as your time horizon.
The idea here is that by the time you do sell, the ocean will rise and fall many times, and you’re basing your strategy on the level of the ocean being higher when you sell regardless of this, because that’s been shown to happen with a pretty high level of confidence in the past.
Whether or not this will continue into the future is another matter, but this is not what we should be looking to hedge, and that’s by far the biggest mistake individual investors make, hedging when there’s no point in doing so.
So, we see a lot of investors going with a more balanced portfolio, for instance half stocks and half bonds, and while some balance is often a good idea, this very often comes in with way too much emphasis on balance in longer term strategies.
This is the case with bullion as well, and with bullion hedging this gets messed up another way, if we just blindly hold bullion positions to presumably protect ourselves far off in the future.
A good example of this would be with people who jumped on gold back when it was trading at very high prices, as a result of so many people buying it after the 2007 recession. Stocks took a big hit generally, and well after the fact, people liquidated some of their stock positions and bought gold.
Gold has gone down since, and stocks have gone up, and we can even wonder how long it will be before gold hits these levels again. It will probably take another recession, and perhaps these people will make the same mistakes again.
Some people took a huge hit in the market, finally sold at the bottom, and used the money to buy gold when it was very overbought, and then added to their injuries by seeing gold drop steeply in price. Adding to your losses this way is not the purpose of bullion hedging.
At this point, stocks represented much more value than gold, and people should have been looking to increase their positions in stock and decrease their positions in gold and other bullion. This is not because this worked out to be the best way to go, it simply is under these conditions, and will be again when this situation recurs.
The Proper Way to Hedge with Bullion
This is not a good example of using bullion to properly hedge stock positions. What we instead need to be looking to do is to move out of stocks and into bullion at the start of the trouble, not after it’s passed and things are rebounding.
With long term stock market holdings, hedging may not even be necessary, and a lot of people just kept their stock positions throughout this turmoil and things ended up getting back on track in time. If this time is well within one’s time horizon, and one does not need to sell, not only is this nothing to be concerned with, it may represent an opportunity to increase one’s positions after all the fuss is over and things start recovering.
If we are actually exposed to the risk of needing to sell during these recovery periods, and therefore would take a loss at least relative to recent valuations, then the first response should be to look to liquidate our positions earlier to avoid holding things through a significant pullback.
In addition, having positions in bullion can also help, because the gains that usually occur with bullion during pullbacks can ease the pain of the losses we endure in the stock market. The point here isn’t necessarily to make money from these pullbacks like traders look to, it is to cushion the blow, which is what a hedge seeks to do.
This may or may not involve holding positions in bullion prior to these events, prior to the hedge being needed in other words, although it may. The most efficient way to hedge this actually is to do what the overall market is doing, moving some of your exposure out of stocks and into bullion, or bonds, although bullion can be an especially good hedge in these situations due to the way its price tends to rise.
Then, as the stock market recovers and more people move out of bullion and back into the stock market, you should be doing the same, as this is going to drive the price of bullion down and the price of stocks up, and it’s even more beneficial to be swimming with this tide.
This does not mean waiting for things to bottom up, as that is too late, you want to act in step with the markets, not after they have made their move. This is a party you want to be early for, not late for, and that’s the case with all investing and trading.
If people play their cards right, they should not be too concerned with any market condition, including a recession, and the smart money does even better in these environments actually, because they play the other side of things. It’s actually easier to make money when something is in steep decline, people are panicking, and a lot of momentum is created. Down momentum is only bad if you’re boat is trying to sail against the wind, not with it.