One of the topics that has been coming up more recently in the financial press and in discussions with investors is hedging in the current market.
This isn't a new topic, but it's one that has attracted increasing amounts of interest recently because the market is looking increasingly overextended. No matter which metric you look at, it is difficult to justify that stock prices at the current level are attractive overall (as measured by the S&P 500). Although there are bargains in some sections of the market, overall, it looks as if now isn't the time to buy.
Unfortunately, the fact of the matter is that there is always someone somewhere trying to predict the next decline with a series of data points to back up this argument. If it were possible to predict the next market slump accurately, everyone would be wealthy, but it's not and with this being the case, trying to prepare your portfolio for the worst is almost impossible.
Hedging is one way to protect against the next downturn, but this strategy can be quite expensive, particularly if the market continues to trend higher (this depends on the instruments used to hedge risk).
No matter which strategy you use with hedging, there is always going to be a trade-off. You are going to have to sacrifice some profit for the insurance policy. Either you pay upfront for the protection or lose out over time as you stay out of the market waiting for the next downturn.
Whenever discussing this topic, I always think back to the advice from Seth Klarman (Trades, Portfolio) who has spoken about the problem of hedging on many different occasions. Klarman's favorite hedge is not a complex setup. It is, quite simply, a large cash allocation: "Our willingness to hold cash at times when great opportunities are scarce allows us to take advantage of opportunity amidst turmoil that could handcuff a competitor who is always fully invested."
Cash gives Klarman optionality, which is by far one of the most valuable tools for investors to have. By holding a large cash allocation, Klarman's portfolio declines will not be so severe in a bear market, and he will be able to be greedy while others are running away. Even though staying out of the market when it is rising might impact returns, the additional gains booked by buying when the market is low will more than offset the lost profits, as Baupost's numbers over the past few decades show.
Holding cash is a trade off, but it is a trade off worth making. As Klarman wrote in his year-end 2004 letter to investors:
"Most investors would make the same choice. Human beings are only endowed with so much patience, after all. Few are able to look past near-term returns, and today anything appears to offer better returns than cash. Also, given their relative-performance-oriented, competitive nature, investors loathe the possibility of underperformance that comes from sitting on the sidelines; they find it better to be in the game (unless, of course, the market drops) ... By holding expensive securities with low prospective returns, people choose to risk actual loss. We prefer the risk of lost opportunity to that of lost capital, and agree wholeheartedly with the sentiment espoused by respected value investor Jean-Marie Eveillard, when he said, “I would rather lose half our unitholders ... than lose half of our unitholders’ money ..."
To be a successful investor over the long term, rigid discipline is essential. Finding, researching and holding investments requires patience and skill.
The same can be said for portfolio allocation. Cash might not seem exciting, but it is the perfect hedge against unforeseen market moves, and a large cash balance also gives investors optionality, which can be used to make bets at the ideal time.
Cash might be boring, but it is essential for long-term investment success.
Disclosure: The author owns no share mentioned.
