Hedging your Investments

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Taking some hedging tips from nature

Volatility has returned to markets, globally, with whipsaw movements that would make even the most seasoned investor queasy. Unless you’re a hardened gambler, you probably don’t enjoy this much, and if you look for advice and reassurance out there you’re going to get wildly contradictory opinions. Is it possible to take advantage of the pockets of investment opportunity, preserve your capital and keep sane?

We plant hedges around our property to protect our privacy and assets, sometimes encroaching on our light and annoying your neighbours – and therein lies one of the secrets of hedging your wealth portfolio. You can overdo it. If you plant a 12-foot macrocarpa hedge, you’re going to crowd out all the light, destroy your flower beds and be the neighbourhood pariah. A dainty fuschia or abelia hedge, however, can be enough for your privacy, pretty to look at and enhance your asset. So, how do you work out the ‘goldilocks’ level of hedging you need in your investments? When you’ve determined that, you can look at choosing the asset classes (or plant species) to use.
In investment terms, hedging is used to flatten out or stop volatility. You can do this in a single asset class like stocks by having ‘stop-loss’ levels where a stock is sold when it hits a predetermined level, either to cash-out your gains or prevent further losses. For the average investor though who don’t have the skills or inclination to play with stocks, the same hedging can come from a balance of asset classes, including currency hedging with an offshore component (or offshore heavy local stocks).

I cannot say it often enough… Every investment should have an objective, and out of that objective will come the timeline and asset allocation. Your ‘risk appetite’ frankly should be the last consideration (and is usually done to cover a financial advisor’s ass(ets) and to comply with the FAIS Act.
Nobody knows what is going to happen in the future so you need to manage your expectations too. In my experience, this is where most of the unhappiness with investments happens – unrealistic expectations.
Each asset class (broadly:- stocks, bonds, cash and property) has an expected behaviour and cycle. A basic understanding of these is essential so that you can understand your portfolio and how and why your investment advisor has recommended a particular allocation. Just like you should never give your landscaper (or spouse) carte blanche in the garden, ever abdicate the full responsibility of your wealth to an advisor or broker.

I have blogged on assets in more detail HERE, so won’t repeat myself too much, but what you need to find is the blend of asset classes that will ensure that the investment bucket meets its objectives. For example, if you have an emergency fund, it must be instantly available and not lose its capital value (so ‘cash’ makes the most sense.) Retirement funds, on the other hand, are going to be dictated by how many years you have to retirement. If you are actually in retirement you need to focus on the ‘yield’ or income you need that pot of investment to produce and for how long. That requires a lot of finesse, and only if you have funds way in excess of your needs can you be cavalier about the investment (quite frankly you could put it all in money market and not have the angst of market risk.) There is nothing more upsetting than realizing you have lost years of potential growth because this exercise was not done properly from the start. As upsetting as that may be, running out of funds when you’re into retirement is devastating.

Part of the secret of effectively hedging your investments is muting your expectations – both to the upside and downside. I know this enters into the fuzzy area of emotions, and your advisor is unlikely to call you out on it, so let me weigh in here. Behavioural finance is a fascinating, and relatively new, branch of financial advisory but understanding some of the behaviours that might be driving your decisions. Is fear or greed the underlying motivation of your angst? Are your decisions based on the recent past? Is the source of the funds influencing your decisions? ( We are inclined to treat windfalls and salaries quite differently). Who is influencing your decision? Are they qualified to do so or is their advice based on their own/historical experience?

In order to understand how natural hedging of your wealth works, you need to have a basic understanding of some maths – and don’t worry it isn’t that onerous. I think most of us know what an ‘average’ is, it is also known as ‘arithmetic mean’ or just ‘mean’. One of the most important things to know about your wealth, and about the different asset classes, are what the average is over time. With your garden hedge you would need to know exactly the same thing – how big will it get over time (and can it be wiped out in one bad frost). If you want to chart your average growth graphically it is usually a straight line, but the data points by day, month or year will bounce above and below this average. This ‘bouncing’ is the ‘volatility’ (deviation from the standard) of the investment or the asset class. In the long term, cash and bonds usually have the lowest average return, with stocks and property higher. You need to give those cycles at least 8 years to get a realistic average. Every investment should be measured against inflation (growth minus inflation giving a real return) because this will preserve your ‘purchasing power’ which is the most basic of objectives for most of your investments (but not necessarily savings – where capital preservation in the short term is the major objective).
The next bit of math that will help you understand hedging is how ups and downs pan out in your balanced portfolio. This is best illustrated with a simple portfolio – say 50% in stocks and 50% in cash. If you had 100% of your investments in stocks, the return was -8% – or 100% in bonds with a return of 8% (unusual historically but our reality in RSA over the last couple of years). It is easy to see where you are, but you’re probably crying into your beer if you had thrown everything at stocks. A simple 50-50 blend, however, would have muted your losses to almost zero (before fees of course). This 50-50 split is the most simple balancing you can do, but getting a ‘hedge’ that suits you and flourishes without stifling your potential growth has to have more finesse. Ideally, you need a diversity of sectors (retail, finance, manufacturing, commodities etc) because they don’t always move in tandem. You also need offshore exposure to hedge against currency moves and mute your exposure to a single stock (not easy with our top heavy JSE – Steinhoff being the most recent example). Most of us understand the money market, but the bond market is not as accessible (more than anything, you need to buy a large tranche, or invest in a portion of a bond via a unit trust, retail bond or other asset managers.

Fees are important, but they should not be the primary consideration in your choice of investment. Goedkoop (cheap) really can be duurkoop (expensive). If you’re using Unit Trusts (aka Collective Investments but nobody seems to use that term – offshore called Mutual funds) then have a good look at the mix of assets. I don’t recommend you (or your financial advisor) try and ‘balance’ this yourself. Avoid Fund of Funds (FOF) they have fees on fees and will erode your return and frankly are often used by asset managers who do not have the skills to put their own unit trust together but want the fees anyway. If you want to use ETFs, again you really need to understand what the ETF is ‘tracking’. If the stock component is tracking the All share Index for example, then you are overexposed to certain big stocks like Naspers, and it just needs a Listeria moment to tank the index. They are great investments for youngsters with a couple of hundred Rands to invest, but where you can get an actively managed fund for just about the same cost as an ETF (here in RSA where ETFs are not dirt cheap like the US). Some of the new ETFs track ‘complicated’ indices – take Buffet’s advice, if you don’t understand an investment, don’t put your money into it.

Action:  Hedging your investment is not rocket science, but you need some basic understanding of what you’re doing and more importantly, what the objective is.

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