There's No Perfect Hedge

February 19, 2013

With the Dow close to breaking the old record of 14,164 set in October 2007, now may be a good time to consider strategies to minimize portfolio downside in case the next crisis hits within a few years.

More noteworthy than the Dow’s vertiginous heights, at least to pattern seekers, may be that the S&P 500, which covers much more of the stock market than the Dow, is hovering around 1,500. The last two times it hit these levels, in 2000 and 2007, didn’t bode so well for investors, with roughly 50% drops each time. 

To all the value investors out there, it's worth noting that the S&P’s drop the second time around was harder and broader than its 2000 slide, despite valuations having been stretched  much further in 2000. So much for the safety of low P/Es and high dividends.

This is noteworthy, because stocks are cheaper today than they were during the last two big tops. Companies are earning more money than they did in the past, so you're paying less for those earnings. And although we believe cheaper investments are safer investments, we "more" believe that investments that have already collapsed are safer still, which is why we usually increase our stock allocations here and in client accounts following major stock slides — not just because P/Es are low. 

Crisis scenarios abound, although as we’ve noted in the past, the most common fears rarely result in collapse. Here's a list of potential anxieties, in no particular order: collapse of the Euro region, a China (maybe) bubble economy, U.S. government debt problems, global inflation triggered by reckless central bank policies, a deep recession sparked by tax increases and spending cuts in a so-so economy, sharply rising interest rates caused by any number of reasons with resulting pain to the economy, and a housing market re-collapse driven by sharply higher mortgage rates from said rise in interest rates. It’s a virtual smorgasbord of financial scariness.

Of course, the most likely path is the path we’ve been on 95%+ of the time in history — a growing U.S. economy with stocks beating 95% of all other investments. But let’s focus on strategies for the other 5%. After all, avoiding big-time losses  is key to long term-returns, and certainly a main reason our model portfolios have outperformed the S&P 500 for the last 10 years.

Here are a few typical strategies for minimizing downside (and upside…) in a portfolio, with some brief notes on the imperfections of each, especially in light of an ever-shifting landscape.

Someone once said that the only perfect hedge is in a Japanese garden. Of course, they said that before the Japanese market slid for 20+ years, but that’s another story. 

What we would like to add to this market cliché is this: the last perfect hedge may be the next poison.


Cash may be king, but with near-guaranteed, perpetually-negative, inflation-adjusted interest rates, cash (as well as shorter-term, top-quality bonds and CDs)  isn't just missing out on the growth of other investments; it's slowly eroding by about 2% each year after inflation and taxes. Although you can still reduce risk with cash since it won’t fall during a stock slide, it's not as helpful as it was back in 2000 and 2007, when cash still paid.


Bonds are usually preferable to cash, since they can go up when stocks go down and pay a higher interest rate along the way. But today's safe bonds often pay only enough to keep pace with the likely inflation rate after tax (or even less) and carry much less upside with which to counter sliding stocks. And this assumes the next stock slide isn't triggered by rising rates, in which case bonds would increase portfolio downside over cash. Even worse, more investors are using higher-risk debt to make up for the yield shortfall, and emerging market bonds as well as corporate "junk" bonds could easily fall as much or even more than stocks when the next Big One hits.


Worried your tech fund will slide? Just own a few other categories — a little value, some growth, a bit of large-cap, etc. Afraid the U.S. dollar or economy will sink? Add some foreign markets. Concerned about major global economic sluggishness? Add emerging markets. Wall Street has a solution for all that ails you. 

While diversification would have saved you from much of the 2000 crash, it was a disaster, if not a risk-increaser, going into the 2007 slide. That's because when everyone does the same thing, it stops working, particularly when you need it to work the most.

Gold and Silver

First off, gold and silver didn’t help in the last slide. Now at even loftier levels, the downside to holding gold and silver could easily exceed the risks associated with stocks. Globally, we already have about a quarter trillion going into gold alone each year – far more than other investment bubbles like dot com stocks. 

Unless you believe the world is going back to a gold standard, gold mines are going to run out soon, or there’s a looming zombie apocalypse, it's hard to make the case that gold can continue to climb far in excess of inflation, year after year, forever. Besides, those that make investment decisions based on infomercials probably won’t get too rich. It would disturb the natural order of things in the universe. Not to mention that lately they're buying the golden coins minted by gold billionaire George Soros is selling.


Prodded by Wall Street experts, investors are piling into investments you can literally sink your teeth into. Can you blame them? With interest rates so low, why not own something with no yield? Commodities, as (sort of) components of inflation, must make the ultimate inflation hedge – and have low correlation to stock prices. I’m not sure when merely matching inflation became a goal in itself, but it’s a poor goal. 

Moreover, the costs of "owning" commodities, in the form of fund fees or the futures-related costs of trying to gain exposure to commodities all but guarantee losing to inflation over time. Even worse, when it hits the fan in the economy and stock market, commodities take it on the chin, which we saw in the last market slide. Guess which index is not near all-time highs? Commodities.


In theory, shorting overvalued stocks or other investments might offer some protection against a slide – in the right hands. In reality, there are costs to shorting (like covering the dividends of that shorted stock and paying to borrow the stock itself), not to mention that stocks generally go up over time. Most of the time, simply owning less stock will beat shorting combined  with a larger stock allocation. 

Market Neutral

This represents the best of both worlds, at least in theory. If you're 50% short and 50% long (owning stocks), you're insulated from stock market swings and will profit solely as a result of  your bets to go up beating your bets to go down. Pure stock-picking power. 

Quite frankly, no one seems to be able to pull this off in mutual funds. What little added value you find is quickly eaten up by above-average management fees. This category of funds – and we’ve dabbled here ourselves – routinely underperforms money market funds, bond index funds, and other lower-risk funds, both in good times and in bad. Even worse, there have been many cases of these safe funds falling as much as stocks in general – only the upside was limited. 

We could write for days about all the different strategies and their shortcomings in the real world, but this captures much of where money goes seeking downside protection.

Next month we’ll review potentially better risk-reducing strategies in an imperfect world. If you haven’t already, please sign up for our FREE email list to be notified of articles and changes to our model portfolios.