Issues with Platinum as a Hedge

When we look to hedge an investment, we are seeking to manage risk with it, and specifically, to reduce the risk of just holding that investment without hedging it.

Hedging is therefore part of the bigger category of risk management techniques, and a secondary one actually, compared to managing the risk of the investment directly rather than indirectly through the addition of different investments which serve as the hedge.

We often think of hedging comprising the primary way to manage risk, but whenever we seek to do this indirectly, we really don’t have anywhere near as much control over risk management as we would if we did this directly, for example with strategies that will have us close our positions when a certain threshold of risk is reached.

What we could call primary risk management does require that our investments be actively managed rather than passively, where we’re actually paying attention to the investments and not just shelving them, and adding some secondary influencers, the hedges, and shelve them as well, and hope things all come out well.

In some cases, this passive approach is at least superior to doing nothing at all, to just ignoring the investment and not hedge it either.

Bonds are a very popular hedge for those with passive stock market positions, and bonds generally do at least dilute risk by not performing as badly as stocks do during stock bear markets, and may even produce a positive return during these times.

If we are looking to use precious metals, and platinum specifically, as a passive hedge like this, we first need to understand what makes a good passive hedge good, and what we’re looking for is something that is less volatile, and at least has somewhat of a negative correlation with the asset we’re looking to hedge.

Bonds fit the bill here fairly nicely, and while we could say that bonds as a hedge just works better if we actively manage our bond positions, using it as an active hedge in other words, bonds will at least reduce one’s risk exposure by using it as a passive hedge.

Using Cash as a Default Hedge

Cash can also be used as a hedge this way, and all you’re doing with cash is losing to inflation, with no further risks involved, but people prefer bonds because they at least seek to keep pace with inflation, at least the inflation that is present when you purchase them.

Cash used as an active hedge is much more powerful though, because we now will default to neutral positions to manage situations where the risk is higher with our primary positions, for instance moving more to cash during bear markets and investing more during bull markets.

The amount of money that we keep in cash is going to depend on the market circumstances of the assets we invest in, for instance if we invest in both stocks and bonds and the outlook for both is inferior to cash, we go to cash for now. Although this is a sensible approach to hedging, it’s not one that many investors use.

When we add platinum investing or other precious metals into the mix, we now have one more asset type to consider, and we then would look to proportion certain amounts to each according to their potential at the time. If all are in bear markets, which can happen, we would stay in cash and wait until things turn around.

The goal of being invested in something is to seek to achieve a positive return, and a sufficiently positive one, while not risking too much in seeking it, so it stands to reason that if the expected return is a negative one right now, if the asset is trending the wrong way, that in itself should have us no longer wanting to stay in it, as long as these conditions persist.

We can look at the platinum market that way, and we really need to given the increased volatility of platinum, and if we are long platinum with a portion of our portfolio when the going is good and in it less or out of it when it is not, this can serve to nicely hedge other positions.

When we use active investment management like this, these other positions don’t really consist of hedges, at least directly, although they do serve as a sort of hedge, as far as improving our performance and flattening our risk curve.

Platinum and Passive Hedging

While you can get away with passive hedging with things like bonds or cash, this is far less the case with an investment like platinum, which really does require that it be much more actively managed.

All we need to do is look at the charts of platinum over the time it’s been traded on exchanges to get some good insight as to why this doesn’t work well as a buy and forget position, in other words, to take a passive approach to holding it.

People do this with platinum and other precious metals all the time though. They just look to invest a certain percentage of their portfolio in the platinum or gold or silver and tell themselves that they are hedging, in the same way that people tend to speculate on these precious metals, without any real plan, similar to what they would do with bonds.

Platinum is a completely different type of asset though, and pretty much the opposite of bonds as far as how these assets behave passively, with bonds being as stable as investments come, and platinum and other precious metals being as volatile as investments go.

If platinum were perfectly correlated with stock market returns, this strategy may at least be worth considering, although this isn’t really the case. We could calculate how much exposure we want with platinum and come up with a good idea of how much we want our platinum to dilute our stock market returns when the stock market is going up, figure out how much of a benefit this hedge would be when the stock market is going down, and if the numbers made sense, we may be able to come up with a beneficial allocation of some sort.

People need to be doing that when they consider any hedge, bonds included, as we do want to make sure that we get some sort of benefit out of the hedge, and not just water down our returns without getting enough back in the bargain. Looking to limit drawdowns in our portfolio is the benefit, the cost is the lesser returns overall on the upside, and by comparing the costs and benefits here we can at least have an idea of what this is costing us and what we may get out of it.

This calculation is limited to passive hedging only, because when we manage our hedges actively, we are managing both of these factors. We will want to have more of our money in the stock market for instance when the stock market is doing well, and less or perhaps even none when it isn’t, and we might even consider taking short positions in index ETFs when it is not.

When the hedge is doing well, on its own, we will want to be in it more, and in it less or be out of it when it is not. As it turns out, this is the only real way to manage platinum properly and safely, whether the goal is to look to hedge other positions or even as a stand alone speculative play.

The reason for this is that some assets are more suitable for passive management than others, with bonds being the most suited, stocks less so, but more so than precious metals such as platinum which aren’t really suited at all to this strategy.

Hedging and Risk Management

If we hedge stocks, which are in need of hedging of some sort, whether active or passive, with something that is even more in need of hedging such as platinum, we go from needing a hedge to needing one even more overall, and that’s just not what hedging is supposed to do.

To put it another way, having all of our assets in stocks, and managing them passively, involves taking on too much risk, so to manage this we’re going to need to look to balance this off with something that is less risky than stocks, bonds for instance.

What hedging passively with platinum does though is takes a portion of our portfolio that is exposed to too much risk and exposes it to even more risk. This does not decrease risk overall, it increases it, the opposite of what we are supposed to be doing here.

We might think, well the stock market is going down and platinum is going up, so this seems like a good idea, at least right now, but platinum can go down a lot as well, and especially if the price is rising and has risen quite a bit, times that investors end up paying attention a lot more to it.

There hasn’t been a single case in fact where platinum has risen a lot and didn’t go down a lot afterward, and when it goes down after a bull run, it really tends to go down, where we can lose half our money or more pretty quickly if we’re not careful.

If this is all actively managed, we may not be too concerned about this tendency, as we can just look to ride it up and get out when the trouble inevitably starts. Managing this passively though offers no such opportunities, as our strategy requires us to take whatever pain the market wishes to dish out upon us.

Therein lies the considerably extra risk involved in using platinum as a passive hedge, its tendency to go the other way so violently, and our lack of direction in looking to do anything but sit back and bear it.

Platinum cannot be safely invested in passively regardless of why we’re doing it, to hedge or for any other reason, because this strategy does not manage the risks involved at all and there are some significant ones indeed.

On the other hand, if we actively manage our platinum hedges and have clear plans to manage these additional risks, platinum can serve to be a very good hedge, especially when we’re allocating money to it from stocks with stocks in a bear market but platinum in a bull market.

There may be no better hedge in fact than using precious metals such as platinum to manage stock bear markets, providing that the conditions are right, but this is going to involve our paying attention to the conditions and seeking out these more profitable opportunities that also serve to minimize our portfolio drawdowns, as all hedging needs to seek to do.