Protecting against Market Drops
Using a different analogy this time, imagine the market to be like a runner. A runner has a certain average pace that they run at. If they run too fast, they get tired, their pace reduces for a period of time before they recover and pick up pace again
The stock market is similar, goes up, corrects for a period of time, goes up again. Occasionally the market/ runner may get an heart-attack, from which recovery is longer.
Protecting against small drops is expensive and may completely wipe out returns. However protecting against "large drops/ heart-attacks" is important for portfolio health.
Protecting your portfolio is through "Hedging Plans"
Simple Hedge
Consider the charts on the left. The red line represents the stock market without any "hedge".
Average return of 9%, but with a 50% drop in portfolio between 2008-2009. It also took the S&P 500 5+ years to recover that drop.
The blue line represents a "simple hedging plan", where you exit the stock market when it drops below the 8 month moving average and move to cash.
Average return of 10%, with a 12% drop in portfolio between 2008-2009. The recover time was also much faster, just 2 years.
Slight increase in returns, but a huge reduction in risk.
Complex Hedging Plans
There are other ways of constructing more complex insurance plans. The one that is most used is one that involves buying "put" options in the market.
Without getting into too much detail, a "put option" essentially protects your position if the market drops below a level that you specify when you buy the put option.
There are also ETF's that are now available in the market which are constructed using these "put options".
However buying these insurance products cost money
Maximizing Hedging Efficiency
Since Hedging costs money, one way of improving returns is to buy "Hedging" only when needed.
This in turn means that we need to distinguish between the probability of a "small drop" vs. a "large drop" in the market. "Large Drops" need insurance. "Small Drops" should not.
All our portfolio plans include in them either a "Simple Hedge" or a "Complex Hedge"
Maximizing Hedging Efficiency
All our portfolio plans include in them either a "Simple Hedge" or a "Complex Hedge"
Simple Hedge: This is when the portfolios increase the allocation to cash in order to protect the portfolio from large drops.
Complex Hedge: This is when the portfolios actively buy ETF's that represent volatility to hedge against a potential drop in the market.
What does that mean for our Clients?
Your portfolio is not going to go up in a straight line and there will be ups and downs.
There will be periods when the portfolio is going to significantly outperform the index, but there will also be periods where it will under-perform the index. This will typically happen when there is a high risk of the market having a "large drop/ heart-attack".
However Asset Diversification + Time Diversification + Hedging gives you a portfolio which over time has a higher return to risk ratio than traditional portfolios.