Don’t Hedge Your Retirement Portfolio
Never hedge your retirement portfolio! This is one risk you must control without a hedge.
Why is “hedge” the riskiest word in investing? Because it demonstrates that you don’t understand risk.
If you are trying to hedge your retirement portfolio, let’s see if you might not pick a more appropriate term.
What is a “Hedge?”
The dangers of “a hedge” come from its definition and use.
As for the definition, it is “an investment intended to reduce risk of another investment.”
The definition includes two equally important considerations. First, you have an investment that directly or indirectly counteracts another investment. Second, the idea is risk reduction.
Well, is a hedge the most efficient way to reduce risk?
Unless you are hedging jet fuel or corn prices, probably not!
Hedge One’s Bets
Hedge came to us via old English (from hedge or fence) via “hedge one’s bets.” A hedge is a hedge of one’s bet!
If you take a bet (and the outcome is thus uncertain), you don’t want the entire upside or downside. This is because you might lose the bet, which is unacceptable.
When hedging one’s bets, you use expectancy to gauge results.
Expectancy is the probability times the outcome. You expect there is a chance you will lose your bet, and you don’t want to lose everything. Zero-sum games need hedges, as do bets.
Investing is not a zero-sum game. Hedging is not required for investing.
So, the problem with the definition is that an investment is not a bet.
Next, people confuse hedging and insurance.
Hedging is NOT Insurance
Let’s be explicit now: a hedge is not insurance!
Insurance involves a risk pool in a non-zero-sum game where the results will be devastating in the event of low (yet predictable) expectancy.
Specifically, insurance relies on future potential outcomes that are unlikely yet catastrophic.
When you invest in the stock market, you are sure the market will go down, and the result is not devastating. It is neither unlikely nor catastrophic that you will “lose” 20-50% of your investment (if you sell and lock in losses). Only if your behavior is bad is the event catastrophic. Look, hedge your behavior, not your investments!
So the future risk of a market correction and an economic depression is 100%. There is no reason to hedge against certainty.
You invest, and you don’t time the market.
Why a Hedge is Not Insurance
Embarrassingly, look at this bit on Investopedia.
Hedging is somewhat analogous to taking out an insurance policy. If you own a home in a flood-prone area, you will want to protect that asset from the risk of flooding—to hedge it, in other words—by taking out flood insurance. In this example, you cannot prevent a flood, but you can plan ahead of time to mitigate the dangers in the event that a flood did occur.
Holy cow, there is so much wrong with that paragraph.
First off, hedging is not at all analogous to insurance!
Flood insurance is not a hedge. Instead, it is an insurable (and re-insurable) interest that might be devastated by an unpredictable yet knowable event.
The market is not insurable (depending on your timeline), and it is utterly predictable that there will be a non-devastating event.
[In a truly devastating market event, do you think any paper hedge will protect you if everything else has failed?]
Instead of hedging, understand when you need the money. If you need it soon, invest appropriately.
But if this is long-term investment money, there is no such thing as a hedge! Your risk in the long term is underperformance, which you certainly do if you buy one investment to counteract another investment!
Never Hedge Your Retirement Portfolio
In summary, hedging is not insurance because you cannot hedge against an event you know will happen. Everyone else knows it will happen, too! By hedging, you lock in your losses.
Remember the definition of a hedge: you buy one investment to compete against another investment you already own. Of course, there is going to be friction. Not only are costs higher in a hedge, but you also lose no matter what.
Hedges lock in losses. Don’t hedge your retirement portfolio.
When Should You Hedge in Retirement?
Please stay away from structured products that your bank or broker sells you.
Also, do not buy an annuity for principal protection unless you want a future income stream. If you want to understand how the insurance industry is trying to distract you with the hedging squeal, read my piece on RILA annuities and get ready to be amazed.
I’ll argue that buffered ETFs may have a role if you have an intermediate use for money or want a bond alternative.
But don’t hedge your retirement portfolio unless you are a farmer or a jet plane. Hedge your behavior instead.
Thre is a reason that, after deciding to invest, asset allocation is the most important decision.
