Hedging Your Investments

 | Nov 26, 2012 | 12:00 PM EST
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Many investors are too quick to dismiss hedging -- aligning your portfolio so that it does well in both good and bad times -- as a sophisticated tool employed by the mega investment funds. Thanks to the huge popularity in exchange traded funds (ETFs), the notion of hedging has apparently become easier to attain for the everyday investor. Inverse ETFs such as those that promise to zig when the market zags have become popular. And if those weren't enough, you now have leveraged inverse ETF's that promise to perform twice or three times the opposite of what the market does.

Albert Einstein astutely observed that all things should be made as simple as possible "but not any simpler." This is sage advice: The more complex investing becomes the more dangerous and risky it gets. Consider John Paulson, the famous hedge fund investor who obliterated the market a couple of years back by betting against housing and subprime credits while earnings billions for himself and his clients. Paulson's big bet paid off that year and won him worldwide accolades. Yet in 2011, similar big bets Paulson made sent his flagship fund down by over 50%. Basic math tells us that Paulson's fund will have to advance by 100% before those investors are back at break-even.

The simplest and most effective hedge is cash. Cash keeps your portfolio intact during any market environment. Short-selling stocks is often used as a hedge and that can certainly be effective. But short selling is quite dangerous precisely when investors believe that they are safely hedged by going short. Short-selling involves borrowing stock in the hope of one day returning those borrowed shares at a lower market price. The basic level thinking is that shorting protects against market declines and that most stocks tend to decline in a broad market selloff.

But there is no guarantee that such declines will take place. It's even worse when investors think they have succeeded if the market declines by 20% while their shorts declined by 10%; they are happy that they have lost only 10% instead of 20%. What is tragically forgotten is the immense risk assumed to obtain that 10%. Because a stock price can only drop to $0, the maximum upside from a short position is 100% -- whether it's Apple (AAPL) shares trading at $575 or Research In Motion (RIMM) trading at $12, at $0 both would deliver a top return of 100%. Conversely, stock prices have no upside limit price, so a short loss is unlimited. Just ask anyone who tried to short Amazon (AMZN) at $75 or $100.

Cash is the simplest and most effective hedge. The argument that cash earns nothing, or, in today's case, that is has a negative real rate of return, is also an incomplete argument. To me, cash is the most valuable call option in investing because it creates a future option on the opportunities of tomorrow. Investors should always think of investment opportunity as not only what exists today but what opportunities remain in the future. When the market was racing ahead in 2006 and 2007, holding cash was deemed a very poor and ineffective investment decision. Little did most investors realize that at time that the "call option price" of cash was cheap. In other words, holding cash during elevated markets is likely to create fantastic future opportunities. A couple of  years later, in 2008 and 2009, when bargains flourished, those who had cash found themselves holding a very valuable option to use in acquiring newly cheap assets.

Whether it's the fiscal cliff, tax rates, macro or micro issues, cash is ultimate protector when valuations are not attractive. The macro environment was in shambles in 2009 but valuations were quite attractive. In 2007, the economy looked unstoppable and valuations were getting shaky. In both instances, valuation -- the price you pay to own an asset -- ruled the day. Valuation still rules and cash is the ultimate option and portfolio hedge.

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