How To Really Hedge Your Portfolio

Michael Douglas and Andy Garcia star as NYC detectives in Japan in Ridley Scott's film Black Rain. Japan's Nikkei 225 index is lower now than when Black Rain premiered in 1989 (still image via Ace Black Movie Blog). 

Below is a recording of my presentation to the Greensboro chapter of the American Association of Individual Investors on October 17th. Here is a summary of the topics in the presentation. 

What Is And Isn't A Hedge

A hedge is something that always rises in value when the underlying security you want to protect declines in value. That definition excludes assets some investors informally describe as hedges, such as gold. If you are long an individual stock that tumbles because it missed earnings, gold won't protect you against that. Consider a current example, Intel Corporation INTC which fell after hours on Thursday after another earnings miss. Shares of the SPDR Gold Trust ETF GLD weren't up after hours on Thursday. In contrast, put options on Intel will be up on Friday, if the stock opens significantly lower. 

Why Consider Hedging Individual Stocks

I quote a JP Morgan Study which found that 40% of Russell 3000 stocks suffered catastrophic losses between 1980 and 2014. The study defined "catastrophic loss" as a decline of 70% or more without recovering. I also discuss how much investors should consider paying to hedge. 

Black Swans And Stock-Specific Risk

Black Swans can drive catastrophic losses in stocks. One example which occurred during the time period of the JP Morgan study was 2008 financial crisis. Gone are Lehman Brothers and a number of independent mortgage companies such as New Century Financial Corporation. Another example of a black swan has been the COVID-19 pandemic of 2020. COVID-19 lockdowns hammered shares of real estate investment trusts such as Simon Property Group SPG. The COVID-19 black swan also drove gym owner Town Sports International CLUBQ to bankruptcy while boosting the fortunes of home fitness company Peloton Interactive PTON

Black Rain And Market Risk

Investors can ameliorate stock-specific risk with diversification and position sizing. However, diversification doesn't protect against market risk. Although we're accustomed to the market bouncing back quickly after a crash, that's not always the case. Japan's secular bear market has lasted so long that Nikkei 225 index now trades below where it did when the film Black Rain premiered in 1989. In the presentation, I discuss ways to hedge against stock-specific and market risk. I also discuss a way to maximize expected returns while hedging. 

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