As I write this, equity valuations are near all-time highs, the federal deficit has tripled to $3.3 trillion, and social unrest is arguably at a level unseen since the late 1960s. And let’s not forget that we’re two months away from what promises to be a close presidential election.
In times like these, I’m often asked how to reduce portfolio risk, such as with the use of “hedging” or “stop losses”. While these are legitimate risk reduction techniques, there are other, more enduring and effective long-term approaches to managing portfolio risk that are important to consider and compare.
In theory, hedging a portfolio against downside losses seems the logical thing to do when one forecasts future market volatility. But hedging is a bit more complicated in the real world than it is on paper for at least three reasons.
First, hedging is most often done through the purchase of some sort of insurance contract—for example a put option—that protects the underlying portfolio from loss. That insurance isn’t free. For example, as I write this, to hedge the S&P 500 Index (SPY) through after the November election would cost an amount equivalent to 5.26% of your underlying portfolio—all paid in advance. Want to hedge a position in Apple? That would cost an amount equivalent to nearly 10% of your existing Apple position. Why is the S&P 500 less expensive to hedge than Apple? Because it’s more diversified—and thus less volatile—than Apple.
Further, because hedging is akin to purchasing insurance, investors should always expect to lose money on their hedges. You read that right. For every hedge purchased by nervous investors, there are investors on the other side of those transactions making the opposite bet—specifically, that the market will rise, remain flat, or fall less than the cost of insurance (in which case they still earn a profit of course). Subsequently, the purchase of insurance on anything—whether it be a portfolio or automobile—is a zero-sum game after expenses. This is especially true in the futures and options markets where investors go to purchase portfolio insurance. If insurance policies had a positive expected return, they wouldn’t be insurance; they would be investments.
Exhibit 1: Sample hedging costs as of 9/8/20201
Finally, designing a perfect hedge isn’t easy. Purchasing insurance on the S&P 500 Index works well if that’s all you own. But a diversified portfolio, by definition, owns significantly more than the S&P 500—things like small cap stocks, non-US stocks, real estate, bonds of varying sensitivities to equities, and more. Fully hedging a diversified portfolio would require a significant number of different hedges—and those expenses can add up fast.
A stop loss is a trade order placed with a broker (or custodian) to sell a security once it reaches a certain price. It’s designed to limit losses on a specific position. But like hedging, putting a stop loss order in place is a bit more involved in the real world than it is in theory for several reasons.
Let’s first understand how a stop loss order works. Assume you buy XYZ stock at $100 and you set a stop-loss order for $90. If the stock hits $90, your shares are then sold at the prevailing market price for XYZ stocks—not necessarily $90. If the market “gaps down”—a situation where the market opens significantly below its prior close—our shares of XYZ could easily sell for far less than $90. Further, it’s still an order to sell; if you’re sitting on unrealized gains in XYZ stock, an executed stop-loss order will result in the realization (and likely the taxation) of those gains. Note that you can only put a stop loss order on stocks or ETFs; you can’t use stop losses with mutual funds.
Second, investors utilizing stop loss orders need to identify what level of losses would be acceptable. Is that 10%? 20%? Or something less? After all, we need to enter a stop loss at a price somewhere less than its current price (otherwise the position would be sold immediately). Yet if you place the stop loss price too close to XYZ’s current price, you run the risk of selling the position perhaps sooner than you’d like. Determining how much we’re willing to lose on our portfolio is often a painfully difficult exercise that results in investors setting stop losses far higher than they should.
Finally, a stop loss order sells your underlying holdings after (or as) they fell in price—just when they arguably were becoming attractive again to buy! Once that occurs, you still need a strategy for getting back in. Subsequently, selling your holdings in a declining market doesn’t necessarily solve your financial challenges—it quite likely creates still more. I’m reminded of the many investors I’ve met over the years who sold during the bottom in early 2009 and are still “looking for a good time to get back in.”
The biggest threat to our portfolios isn’t the market; it’s ourselves. There’s been more wealth lost to poor planning, a lack of planning, and investors’ emotions than from market declines. The evidence bears this out. The average equity investor over the past 30 years earned a paltry 5.04% annually versus 9.96% for the S&P 500 Index. A simple, diversified portfolio—one consisting of 50% stocks and 50% bonds—returned 7.9%.2 Why the underperformance? Because too many investors think they can see the future. Academics call this underperformance the “bad behavior penalty”. What’s stopping us from investing in a diversified portfolio? Only ourselves.
Our investment objective shouldn’t be to beat the market or time the next market cycle. Those are fools’ errands that all too often result in financial ruin. Our objective should be something greater and simpler—to achieve and maintain long-term economic security for our families and ourselves. And we believe that requires two things: (1) working with a trusted advisor to help keep our emotions in check and (2) a low cost, globally diversified portfolio.
“Diversification” is a term that’s often said but not always understood. For the sake of simplicity, “more is better.” Owning one stock is obviously undiversified and probably not a great portfolio for weathering a serious market correction. Owning many hundreds of U.S. stocks, across all major sectors of the economy, is better but still leaves significant room for improvement. What’s better still is owning thousands of global stocks across multiple countries (e.g., U.S., Europe, Japan, etc.), asset classes (e.g., large cap, small cap, emerging markets), and factors (e.g., momentum, value, quality, etc.). What’s even better? Adding additional asset classes to our portfolio that are uncorrelated to stocks, things like high quality bonds, private credit, and private infrastructure.
To be clear, there’s nothing wrong with using hedges or stop loss orders to protect one’s portfolio. These are legitimate techniques for reducing portfolio risk. However, we take a different approach. In our view, hedging via the use of options is costly and sub-optimal for long-term investors. And the use of stop loss orders is both counterintuitive and only leads to other, perhaps more problematic challenges. Alternatively, we believe two better approaches to managing portfolio risk include high quality global diversification and working with a trusted advisor to control our emotions.
1 Source: Chicago Board Options Exchange
2 2020 QAIB Report
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