Over the past several trading sessions, each time you watch how the major indices are performing, it would seem like they have a mind of their own. Pundits and analysts have been stymied in trying to predict direction. Just when the technical signs tell us that the down-slide is nearly over – we slip even further down.
So, what can portfolio managers and individual investors do in a climate where there’s so much uncertainty? It looks like volatility is here to stay for a while, so how can you make it your friend and benefit from it? One word: Hedging!
Hedging Your Bets
One can’t recommend any specific hedging strategy without knowing what a specific portfolio contains, or what the objectives of the individual are (Long-term growth? Income? Risk aversion?). With that said however, here are a few ways that you could hedge your bets in uncertain times.
1) Pairing Sector Hedges
Let’s start by looking at how including stocks from diverse sectors in a portfolio can be used as a good hedging tool. For instance, assume your portfolio includes shares in General Motors Company (NYSE:GM). Given the rather cyclical nature of the auto business, we’ve seen how economic downturns (like 2009) can adversely impact auto-buying. In tough times therefore, GM is likely to either do nothing much (be neutral), or significantly drag your portfolios’ performance down.
To hedge against a stock like GM, it might be a good idea to include a good defensive name – something that will gain in value during economic down turns. As illustrated by the long-term trend chart above, Costco Wholesale Corporation (NASDAQ:COST) makes a great hedge against GM.
2) Betting on Gold as an Inflationary Hedge
If you are expecting an inflationary economy ahead, as some analysts predict will happen because of rising wages and fuller employment, then gold is your hedging vehicle of choice. Even as inflation drags the value of the dollar down, gold will maintain its value – or not sink as much as many inflation-sensitive stocks.
As is indicated in the pattern of the two tickers in the chart above, in the low-inflationary environment that we have experienced over the past several years, an investment in Costco Wholesale Corporation (NASDAQ:COST) would have seriously over weighted your portfolio (unless you trimmed regularly) in favour of consumer discretionary investments.
If inflation were to rise, consumers would likely cut back on discretionary spending, which could impact the stock price of tickers like COST. The SPDR Gold Shares (NYSEARCA:GLD) is therefore a good hedge against names like Costco in your portfolio.
Of course, if you are a more knowledgeable investor, you might use other complex hedging strategies that involve Futures and Options. You could also deploy clever Stop Loss strategies to hedge against potential losses during a down turn. However, sector diversification and investing in Gold is a simple way to build some cushion into your portfolio and give it some down side protection – especially in volatile market conditions like we’ve been experiencing in the last few weeks.