Protect Your Future With Hedging

| July 13, 2010 | 0 Comments

“The aim of the wise is not to secure pleasure but to avoid pain.”  When Aristotle uttered those words over 2000 years ago, he wasn’t talking about investing.  More likely he was referring to politics or ethics or something more esoteric than the stock market.  But I think his words make for excellent investment advice.

You see, there’s something huge missing from most portfolios out there. It’s something so obvious – but it’s blatantly ignored by most financials advisors.

What I’m talking about is hedging.

Around the time of Aristotle, we first started seeing hedging.  Olive farmers could use olive “futures” to protect their profits in case the harvest didn’t turn out as expected.

Look, this isn’t a new concept.  Hedging has been done for hundreds, if not thousands of years!

So what exactly is hedging and how can you use it?

Basically, it’s a way to protect yourself against an unwanted move in the market.

Let’s say you’re a farmer and you decide to grow wheat this year.  Most years, you harvest your crop and sell it for profit.  But, what if all the other farmers in your region also decide to grow wheat?  So much wheat is produced, there’s too much supply and not enough demand.  Prices drop and you lose money.

But… you don’t have to be subject to the whims of the market.  This is where hedging comes in.

You can protect or hedge your wheat by selling wheat futures.  If wheat prices drop, you make money on your futures which offset the loss from your crop.  On the other hand, if wheat prices increase, you make money on your crop.  You’d lose on the futures but far less than what you’d be making on your wheat crop.  Either way you come out ahead.

Sounds easy enough, doesn’t it… but most of us aren’t farmers.  We probably don’t own wheat (or any other type of agricultural product).  You probably only notice wheat prices when the price of bread goes up at the local grocery store.

If you’re like me, you probably own stocks, bonds, and mutual funds.  Good news… you can hedge these too.

It’s actually easy to protect your portfolio from big market moves.

So why don’t more people do it?

There are many different reasons why you don’t see a lot of mainstream hedging.  But, I’m going to focus on the one I think is the most important.

Greed…

It’s simple really.  Financial advisors, fund managers, and just about anyone else giving investment advice are biased.  They all make money the same way.  The higher returns, the more they make.

But hedging doesn’t maximize returns… it protects them for a small cost. This means less money for advisors.  Your advisor has no incentive to protect your nest egg.  It’s up to you.

Let me repeat that.  It’s in your best interest to protect your money and future against losses.

Take a look at this example…

You decide to hedge your portfolio.  The stock market goes up 10% in a year and your portfolio is up 8%.  The 2% difference is the cost of your hedge.  You still made money and had a nice year.  More importantly, your retirement is safe.

But what if the market goes down 20%?  With a hedge in place, you might be down a couple percentage points.  Or you may even break even on the year.  Without a hedge, you’re down 20%…

How’s your retirement looking now?

Fortunately, hedging is easy to do.  You won’t need expert financial advice to do it yourself.

Here’s the best part, there’s a bunch of ways to hedge your portfolio.  The easiest way is by buying any number of the ETFs taking the short side of an index.  (For example, there’s an ETF which moves the exact opposite of the S&P 500.)  There are also mutual funds which take the short side of the market.

Personally, I prefer using options to hedge.  I’m not going to get into the finer points of options now.  But let’s just say they maximize your portfolio protection without costing you a ton of money.

Figuring out how much to spend on hedging is a personal preference. Entire books are out there on the subject.  But let’s keep it simple… decide how much you’re comfortable spending to insure your portfolio stays safe.

Think of it like car insurance.  If you have a $40,000 car, would spend $500 or $1000 a year to insure it?  Use the same logic to hedge your investments.

Remember, your financial advisor won’t recommend a hedge.  Mutual fund managers won’t be hedging either.  But when you put on a hedge, you’ll be happy knowing your future is safe.

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Category: Stocks

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The Dynamic Wealth Report works with a number of staff writers and guest experts who specialize in everything from penny stocks to ETFs to options trading. These guest analysts post under the 'staff writer' moniker for ease of use.

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