A lot of investors believe that to hedge a portfolio requires complex calculations. They also believe that options and a variety of positions must be put in place and held mid-term to even possibly long-term to “properly hedge” a portfolio. Nothing could be further from the truth. Many investors also believe that hedging is like insurance – it costs money to protect a portfolio. A lot of financial planners will advise clients that just like insurance hedging is a cost that is necessary to protect a portfolio and just like insurance, it may never be needed. What they are actually saying is, this is a cost to a portfolio that may never be recovered. In other words it is capital lost.
Capital Lost versus Capital Gained when Hedging
Hedging for most investors then is capital lost and I do not like losing capital. The only way for a portfolio to grow is to compound capital. Capital must constantly be growing and insurance through hedging is not growing capital. Instead by spending capital in hedging a portfolio particularly mid to long-term, an investor is hurting his portfolio twice.
First an investor often will find that the hedge expires worthless or with most of the capital lost because the market does not correct enough to make the hedge profitable. When the correction is severe and the hedge does have a profit most investors never close and unwind the protection because they worry there is still more downside ahead and they want the protection to stay in place. In other words, this is an opportunity for profit that has been lost.
Second, the capital spent in the hedge is capital that could have been used to continue to grow the portfolio but instead it is locked into an insurance style investment which more often than not yields no gains only losses.
Hedging Should Not Result In Losses – Ever!
I do not like losses. I worked hard for my capital. I spent hours studying companies and risking my capital in investments. I believe my capital should work as hard as I do. This means my hedging must provide a profit as well as protect against losses. To that end here is how I hedge my portfolio to protect and profit.
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This is part of a series on Understanding Hedging A Portfolio To Protect and Profit.
The other articles are listed below and are updated as new articles are added.
Understanding Hedging A Portfolio To Protect and Profit
8 Simple Strategies To Profit From Bear Markets and Corrections
Handling A Market Corrections Through The 50-100-200 Day Moving Averages