As the trade war ratchets up and political uncertainty engulfs Europe, the global markets are looking more vulnerable to downside volatility by the day – particularly with valuations at such steep levels. For some investors, the growing possibility of a market downturn means one thing: it may be time to hedge your portfolio.
For newer investors, ‘hedging’ a portfolio means making an investment or taking a position in a security with the intent of off-setting price movements of other securities in the portfolio. In the current environment, for example, an all-stock portfolio could be hedged by something that tends to rise as stocks fall, like bonds or put options.
Given that over the last 100 years, 5% pullbacks typically happen about three times a year, 10% to 15% corrections every one to two years, and 20% bear markets every three to five years, hedging could make good sense for many investors. So, how do you hedge a portfolio?
Here are five ideas.
This first idea is a classic strategy that is probably not new to most readers. Own a portfolio of different sizes, styles, and sectors of stocks, have an allocation to fixed income (bonds), and viola. You’re done.
But these days, diversification takes on a whole new meaning, given that securities such as ETFs now allow investors to have positions in an array of new asset classes, from commodities to real estate, to alternatives and even to cryptocurrencies. Diversifying a portfolio means much more than just owning stocks and bonds, and investors can get creative.
Increase Allocation to Defensive Categories
There are economically-sensitive sectors like Consumer Discretionary, Industrials, and Financials, and then there are traditionally ‘defensive’ sectors that tend to do better (relatively speaking) during sluggish economic times. These sectors include consumer staples, utilities, and healthcare. Tilting your portfolio allocation’s to more defensive sectors could help to offset volatility in other sectors/positions that tend to be more economically sensitive.
Explore Your “Options”
Buying put options could be another strategy for building a hedge in your portfolio. In this case, you could essentially “buy the option to sell” specific securities in your portfolio at a set strike price. In the event, the security’s price declines, you could exercise your option to sell at a higher price. Buying a put option is a lot like buying an insurance policy – if you don’t use it, you lose the premium (cost of the option) but limit your downside otherwise.
Another option could be to sell the market or some of your securities short, which essentially means selling shares at the current price in anticipation that prices will decline. When you sell short, you collect the proceeds of the sale and then promise to deliver the shares at a later date. Assuming those shares are cheaper down the road, you can return the shares and pocket the difference.
Given how expansive the ETF world has become in recent years, there are several ETF options that could serve as a hedge. They are usually labeled ‘inverse ETFs’ and are designed to do the opposite of what a sector, region, or the broad market does. It is essentially like shorting, but the logistics of managing the ETF are handled by a third party – not you.
Raise Some Cash
Finally, you could just do things the old-fashioned way and raise some cash. If the market does indeed decline, you won’t feel the impact as much and you’ll also have cash available to reinvest at more attractive valuations. The downside is that if you raise cash and the market goes up, you don’t have that exposure. Sometimes peace of mind feels better, though.
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