As Carl Richards at behavior gap says in plain language what many have felt this past year. “Losses hurt [a lot]!” The question is what can an investor do to mitigate the risk of unprotected equity investments. To answer this we need a couple of definitions.
The word hedge has many definitions including some related to investment:
a. A means of protection or defense, especially against financial loss: a hedge against inflation.
b. A securities transaction that reduces the risk on an existing investment position.
The world diversification also has a number of definitions including:
To distribute (investments) among different companies or securities in order to limit losses in the event of a fall in a particular market or industry.
Oftentimes the two words get fudged in the world of investments. One can see from these definitions that these two things are in fact different. Diversification is designed to create a better risk/return trade-off. Whereas hedging is designed to eliminate or offset the risk of any particular security.
(The use of the term “hedge fund” to describe the wide variety of private investment vehicles in existence today is another misnomer. Many hedge funds today are not designed to mitigate risk.)
It would be nice to think that through simple diversification we could eliminate risk without reducing potential returns. Some analysts describe this as an all-weather portfolio. Unfortunately no such thing exists. Why?
In a widely cited piece Richard M. Ennis in the Financial Analysts Journal notes how leading up to the financial crisis many touted alternative investments as having “uncorrelated returns” with equity-like returns. That proved to be a myth the past year as nearly all risky asset classes declined in lockstep. Ennis writes:
But there is no free lunch in asset allocation: If you hope to collect the risk premium, you must bear the risk…The notion of the existence of “uncorrelated return” assets with handsome risk premiums flies in the face of financial theory and conflicts with empirical evidence.
Therefore to truly eliminate risk one must invest in asset that by definition have either no or negative correlation with the major asset classes. During the crisis it turned out that bonds proved to be just such a safe haven. However one cannot guarantee that every bear market will be accompanied by lower long term interest rates.
The Pragmatic Capitalist has an interesting piece up that looks at the ever-evolving nature of market correlations and how having some intellectual (and strategic) flexibility can help an investor. We recommend you read the entire thing, but here’s a relevant quote:
Traditionally, the investment community has believed that real estate, private equity and hedge funds are uncorrelated to equity markets. Why they thought this would be true ad infinitum is beyond me. Markets are non-linear dynamical systems. They will never be the exact same in two different instances. Therefore, all assets are destined to operate differently in different instances.
The one instance TPC notes in which this is not the case is cash or more properly cash equivalents. Cash, assuming it is relatively risk-free, can serve as a hedge against equity market risk. In our discussion of how one might structure a portfolio going forward we discuss the addition of a tranche of assets that are in a certain sense risk-free. One such asset that fits that bill in every market environment is cash. Besides safety the one benefit from this approach is that these assets will likely have little or no correlation with risky asset classes.
A more nuanced approach to asset allocation going forward is going to include exposures that go beyond equities and cash. This adaptive asset allocation approach realizes the need for a broader palette of assets and exposures to create better risk-reward trade-offs. This approach implicitly rejects the notion that there are “uncorrelated returns” out there for the taking.
All that being said, cash is not an investment. Over the long run after taxes and inflation one can at best hope to break-even on cash. In that sense it is better thought of as a store of value as opposed to a return-generating, long-term investment. Nor is cash pain-free. The pain of holding cash is directly proportional to the opportunity cost of being out of the market(s) during a move up. However it remains as one of the ways investors can hedge against equity market risk. The same cannot be said for that now discredited litany of alternative assets.