For investors who rely on income from their investments or become anxious when the stock market zigs and zags with little predictability, there’s a solution.
It’s called hedging against risk. Basically, this means strategically using investments alongside stocks to offset your portfolio’s potential losses in volatile stocks.
“You might not gain anything in a down market, but you might reduce money disappearing out of your account as fast as you would have if it was all in stocks,” said Craig Cowles, a certified financial planner and partner at Cardinal Wealth Advisors. “If the market goes down 5 percent, your [portfolio] might have only declined 2.5 percent.”
Generally, the need to hedge against risk is based on your risk tolerance, along with your risk capacity, which simply means how long until you need the money you have invested. The shorter your “time horizon,” the lower your risk capacity.
“If it’s going to be for a down payment on a house, or for a vacation home or anything you need it for soon, I’d say don’t have it in [stocks],” said Tom Balcom, CFP and founder of 1650 Wealth Management. “A lot of people look at investing as a short-term thing. That’s gambling with your investments.”
On the other hand, if you are saving for retirement and don’t need the money for a decade or more and you can stomach the idea of your stock-laden portfolio dropping in value if the market drops, you probably don’t need to hedge against risk. After all, say most advisors, the upside potential for holding on to stocks for the long term outweighs market volatility in the short term.
Keep it simple
But if you have a low risk tolerance or you need the money in your investment portfolio now or soon, hedging can be a valuable way to protect your assets and help you sleep at night during a bear market.
Catherine Valega, a CFP and owner of Green Bridge Wealth Management, uses alternative investments, such as real estate and business development companies, to hedge against risk.
But her advice, which echoes that of her peers, to those not working with an advisor?
“I wouldn’t try to do fancy alternatives,” Valega said. “The average investor doesn’t have time to do the research.”
The easiest tools for hedging against risk, whether employed by a do-it-alone investor or a financial advisor, are bonds or cash.
Bonds, often called fixed-income securities, are considered low risk if they are issued by the U.S. government or municipalities. Corporations also issue bonds, but they typically are viewed as higher risk in the bond world. However, because of that, they tend to pay higher interest rates than bonds issued by governments.
Municipal bonds, commonly called munis, come with a bonus: The interest earned on them is exempt from federal taxes and, depending on where you live, can be free from state and local taxes, too.
The easiest way to participate in the bond market is through bond mutual funds, of which there are more than 1,900 available to individual investors, according to fund tracker Morningstar.
However, with less risk comes less reward.
Bond investments historically have returned less than stocks. For the 10 years ending last Sept. 30, the S&P 500 Index—a broad measure of the stock market—delivered average annual returns of 8.1 percent. The U.S. bond market during the same time returned an average annual return of 4.6 percent.
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Some financial advisors go beyond bonds and cash to hedge against risk. Their choices can range from real estate investment trusts to commodities.
“The more we can diversify across asset classes, the more we can protect assets,” said Eric Roberge, a CFP and founder of Beyond Your Hammock.
Real estate investment trusts, or REITs, were once uncorrelated to stocks. But when the U.S. headed into recession in 2008, that correlation changed. However, as with any type of investment, that could shift on a dime.
Valega of Green Bridge Wealth Management is a fan of public non-traded REITs that are invested in senior heath-care housing.
“The fastest-growing demographic is people 75 and older,” Valega said. “The rates on loans made to this [housing type] will likely outperform the market.”
Commodities are also used by some advisors. Basically, commodities are products such as oil, wheat or gold that differ little among producers and are used in the production of another product.
“Hedging against risk is not using the stock market as a benchmark. It’s using your [financial] goals as a benchmark.”
They typically are bought and sold on an exchange using what are called futures contracts. These contracts basically are agreements to buy or sell a set amount of the commodity at a particular point in the future. Commodities largely are based on supply and demand and therefore do not necessarily correlate with the stock market.
Balcom of 1650 Wealth Management said one investment used by his firm to hedge against risk is structured investments— specifically, a combination of bonds and options. In other words, they are complicated.
“We use them as a hedge against volatility,” Balcom said. “It squeezes some of the risk out of the portfolio.”
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Financial advisors agree that if you want to hedge against risk and go beyond cash and bonds as a way to mitigate volatility in your investment portfolio, you should consult a professional.
“Hedging against risk is not using the stock market as a benchmark,” said Roberge of Beyond Your Hammock. “It’s using your [financial] goals as a benchmark.”
—By Sarah O’Brien, special to CNBC.com