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Hedge, hide or hold

By Dr. Don Taylor · Bankrate.com
Wednesday, July 2, 2014
Posted: 11 am ET

© Galushko Sergey/Shutterstock.comMy blog post last week discussed Nobel laureate Robert Shiller's CAPE Ratio and how it showed that stocks are valued at a level not seen since: 2007, 1999 and 1929. In that post, I suggested that equity heavy investors should consider rebalancing their portfolios.

I'm going to play on a variation of that theme in this post, talking about whether to hedge, hide or hold. When investors hedge an investment, they look to protect against losses, but typically at the cost of limiting the upside potential as well.

A put option, held in conjunction with a long position in a stock, will allow the investor to continue to make money in the stock if it goes higher, but the return is reduced by the cost of the put option. A put, for the uninitiated, is the right to sell the security at a set price over a set time period. Combining buying a put with a long position in the stock sets a floor price for the stock, while the investor still owns the stock and makes money if the stock price goes higher. The cost of this insurance policy is the price of the put option.

I have a pet theory that hedging is going to become more popular as the baby boomers continue to move into retirement. They may still have an investment horizon of 30 to 40 years, but they can't take the shock of a big drop in the value of their retirement portfolio, and equity-indexed annuities are unlikely to be the solution to this problem.

The decision to hide, is to sell the position and move into cash. While your money is sitting on the sidelines, the person who bought the shares from you is now "in the game." The problem with selling your positions and hiding out in cash is that you then have to decide when to get back into the market. By and large, individual investors are lousy market timers, and you can leave a lot of money on the table is you decide to cash out and the market heads higher. If you don't know what is going to tell you it's time to get back in, that's a problem. Ask yourself the converse, too. What's making you want to sell?

Hold is the "stay the course" approach. Instead of incurring the cost of hedging, you stay in your investments, waiting for a clear sign that the decision to hold is going against you. Trailing stops, as I've written about in an earlier blog post, can force a sell discipline while allowing you to continue to participate in the market's upside. A filter rule can do almost the same thing, where the investor says, "I'll sell this position if it falls 3/5/10 percent off its high."

Hold also works if you expect the market has to go higher over time. Stocks historically have earned a real (after inflation) return of about 7 percent. While 2001 to 2009 was the "lost decade" for stocks when cash had a higher return than the U.S. stock market, we've bounced back nicely from those dark days.

What do you think: hedge, hide or hold?

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