In praise of hedging

The Dow dropped more than 500 points on Dec. 10, only to finish the day in positive territory.

Now, even a few months ago, a massive swing like that would have been news.

These days, it’s just par for the course. Wild swings are the order of the day.


Seeking Answers

Whenever we see moves like these, investors are hardwired to look for an explanation. They want to know why the market cratered or why it blasted higher.

Was it the arrest of a Chinese executive that signaled a worsening of the trade war that pulled the floor out from under the market?

Or was it softer language from a Fed speech that lit the fuse for a rally?

In my view, that’s simply not how markets work.


Auction Dynamics

In my opinion, stock prices work just like any other competitive auction.

When there are more buyers than sellers, prices rise. When there are more sellers than buyers, prices fall.

For the past two months, there have been more sellers than buyers, which is why the general direction has been down.

Extremes Rule

But beyond that, in my opinion, corrections and bear markets also tend to be a lot more volatile than healthy bull markets.

Everything gets more extreme. Stocks fall harder on down days and shoot higher on up days, and intraday swings gets larger as well.

Some investors choose to simply buy and hold and ride out rough patches like these.

Most corrections tend to be short and relatively painless, after all, so why bother selling to try to avoid downside if you’re just as likely to instead miss the upside when the bull market resumes?

Excessive Conservatism

That sounds great, of course. But some of those relatively painless corrections end up sliding into full-blown bear markets like 2008 or 2000 to 2002.

Rather than ride it out and hope for the best, some investors prefer to dump everything and sit in cash until the coast is clear.

That sounds great too. The problem is knowing when to get back in. Excess conservatism can cause you to miss major rallies when corrections turn out to be a lot shallower than feared.

Hedging Strategy

Instead, I hedge. I reduce my usual position sizes in the value and momentum stocks I recommend by half. I then use the 50% of the portfolio that is free to take a short position in the S&P 500.

So, instead of running an aggressive long-only stock portfolio, I run a hedged, market-neutral portfolio. At this point, the market can go up down or sideways, and I’m prepared for it.

Let’s say the market tanks on me. My portfolio’s value and momentum stocks might take a hit, but any damage is offset by the returns I earn from the short position in the S&P 500.

Likewise, it’s perfectly fine if the market rallies. Sure, I’ll lose money on the short position in the S&P 500. But my value and momentum stocks should enjoy a nice bump.


In my view, the important thing is that I don’t have to guess the direction of the market.

I simply have to choose a portfolio of attractive value and momentum stocks that are poised to either gain more or lose less than the S&P 500.

And once the correction is over, it’s back to business as usual. I close out the short position and increase the position sizes in my value and momentum stocks to their regular levels.

Photo Credit: Tim Green via Flickr Creative Commons