Tuesday, March 25, 2014

Hedging your investments 101

If an asset is expected to lose money in the long run, it can't help your portfolio, right?  Generally that's true..  however, in special circumstances, it may actually help stabilize your investments if it exhibits negative correlation with your portfolio.  Let's show an example here:

Your portfolio's returns -

Year 1: 15%
Year 2: 15%
Year 3: 15%
Year 4: 15%
Year 5: 15%
Year 6: -50%

6-year ROI: 0.567%
Compound Annual Growth Rate: 0.09% (essentially 0).

The negative-returning asset's returns:

Year 1: -10%
Year 2: -10%
Year 3: -10%
Year 4:: -10%
Year 5: -10%
Year 6: 50%

6-year ROI: -11.4%
Compound Annual Growth Rate: -2.00%

What happens at the beginning of each year you invest 50% in your original portfolio and 50% in this asset that gets negative long-term returns?

Year 1: 2.5%
Year 2: 2.5%
Year 3: 2.5%
Year 4: 2.5%
Year 5: 2.5%
Year 6: 0%

6-year ROI: 13%
Compound Annual Growth Rate: 2.08%

Wait, what?  How did this happen?  We ended up with an even higher return by adding an asset that overall lost money over 6 years!

People often dismiss assets like long-term Treasuries or Gold as bad long-term investments and I definitely agree, at least if you invest 100% in Gold or Treasuries.

So that means the next time you hear of a bank that's about to fail in the news, you should go out and buy its stock because it'll stabilize your portfolio?  If you answered YES, you FAIL!

Your negative-returning asset needs to exhibit negative correlations with your main income-producing assets (i.e. your Stocks and Equity funds) and it needs to be something that investors will flock to during a liquidity crisis (like in 2008.)  Gold and especially Treasuries fit this bill despite their zero to negative real returns over time.

This may sound a bit technical if you don't know your math and statistics but the point I want to make is that simply saying an Asset produces negative returns in the long run is not a good enough reason to exclude it from your investment portfolio.  That's pretty much a straw-man argument, although it doesn't prove it should be included either.  Instead, think about how adding that asset will change your portfolio and is that change beneficial in the long run!  It's one thing if you're new to investing and shun Treasuries simply because of their zero real returns but I've encountered many CFA Charterholders who think the same way.  This is quite a shame as I'm currently studying for the CFA Level 3 exam..  anyone who has endured preparing this grueling exam has practically been bombarded with variations of the following mantra: "Always think of investments in a portfolio context and not in isolation!"

You won't need to hedge your portfolio with that negative returning asset if you know when that -50% return in your equity portfolio is coming.  However, from experience (in 1987, 2000, and 2008), most professional portfolio manager didn't seem to know let alone the little retail investor.  Hedging, if properly performed, will not only reduce the impact of these big drawdowns but also smooth out your portfolio's returns, making it easier to sleep at night.  I'll discuss the Permanent Portfolio and a few other techniques that contribute to this sort of hedging and smoothing out of returns in subsequent posts.

No comments:

Post a Comment