Episode Summary

Today on Agile Finance Radio, we’re going to talk about the Coronavirus Stock Market Rally and four options that you have to hedge your portfolio in times of uncertainty.

Key Points

  • Never argue with the market.
  • Learn about four options to consider as a hedge for your portfolio.

Resources

Learn more about how options work

 

Transcript

Today on Agile Finance Radio, we’re going to talk about the Coronavirus Rally, as I’m calling it, and we’ll take a look at what you should think about when hedging your portfolio and some ways that you can accomplish it.

Stock Market Update

For the past few weeks, I’ve been focused on clients, the market, and studying what’s going on. I find it fascinating to see what the market does and how people respond. Unfortunately, I just haven’t had a lot of time to focus on the podcast. I should get back to regular podcast updates now.

The last time I gave an update, I mentioned that we had seen a character change in the market. At that point, we started putting money to work. The market was telling us something different from all the negative news. There was a lot of fear out there, and if you listened to the news, you were probably feeling anxious, and understandably so. Even now, the picture is still just as fuzzy, with 30 million people out of work.

Looking at the stock market, you wouldn’t think that is the case. I know the stock market is always looking forward, and it’s evaluating information now and trying to forecast what it will be out in the future. This is new territory for the character of the stock market. I can’t find a similar situation that has happened before like this.

We’ve never had a rapid descent like this in that short of a time frame. And now, the recovery is coming quickly as well. It’s not as steep as the vertical cliff down, and that is a good thing, in my opinion. This just goes to show you that no one can predict the future, and you have to have your money positioned in a way that is appropriate for your stage in life.

Unfortunately, I know some people that exited the market, and I hope that fear has not grabbed them so tightly that they can’t take advantage of the opportunity before them. We all have to be able to sleep and night, and no one should be obsessing over their portfolio. If that’s the case, then and adjustment is probably needed.

This is when having a trusted advisor can help you through the rough waters and navigate you through the storm to safety.

Okay, let’s move on to talking about ways to hedge your portfolio.

What is Hedging?

Before we go into the examples, let’s define what it means to hedge your portfolio. You’ve probably heard the term hedge your bets, which basically means you are trying to limit your loss. Hedging is simply a means of transferring risk. In finance, you typically are trying to hedge one investment with a different type of investment. For example, you may hedge stocks with a portion of bonds to manage risk.

So we are trying to reduce the risk of our portfolio so that we don’t have a huge drawdown based on our life position. Let’s talk go over some hedging strategies.

Cash is King

The first one is the simplest of all; it’s cash. Some of you might be thinking cash is not a hedge. But remember what a hedge is, it’s a transfer of risk. How much risk is there to your cash? Next to zero, right? As the market was crashing in February and early March, did your cash lose 30 percent? Of course not.

The problem with cash is that with it having little risk, there’s not much return, so it’s not a long-term investment strategy. So how do you use cash?

For one, in my opinion, you should have some cash available in a savings or money market account. This is for the unexpected expenses, sudden job loss, or if you are retired where you pay for your living expenses. You don’t want to have to sell part of your portfolio to pay for living expenses when the market just crashed 30%.

Another option is, if you have a more active portfolio, you can go to cash when you see the storm coming. I don’t recommend this for everyone unless you have the skills to manage a portfolio and have a system for helping you reduce size and then tell you when to get back into the market. Also, I would never recommend going to 100% cash either, since no one knows what the market will do.

Asset Allocation and Diversification

The second way to hedge your portfolio is by using asset allocation and diversification. Asset allocation is how much you will put into a certain investment. Think of it as the percentage or weight of how much that asset will get in your portfolio. This is one of the best ways to reduce risk in your portfolio and also the volatility, which is the amount it fluctuates over a period of time.

What would be the types of assets that you would purchase? It would be things likes stocks, bonds, commodities, real estate, and cash. Those are the assets that you want to place your money in. Having the right allocation is one of the most important things to do to reach your goals. Your asset allocation will most likely change over time because the closer you get to retirement, the less risk you can take.

Diversification is related to allocation, and some people may interchange those terms, but they are different. Diversification applies to what are the investments that I will choose within an asset class.

For example, if you want stocks, what will I choose? Should I put it all in one company? Probably not. There’s big companies like Apple and Microsoft, small companies that you probably haven’t heard of unless you are really into the market or international companies, and emerging companies.

It’s the same for bonds as well. Do you you want government bonds, company bonds, international bonds. Within those, there are other ways to diversify.

The point of asset allocation and diversification is to allocation money across assets that aren’t correlated. For example, when stocks are going up, bonds are typically going down and vice versa. That’s not always the case, and that’s why asset allocation isn’t magic, but overall there are advantages to spreading your money across different investments.

Electronic Traded Funds (ETFs)

Another way to hedge is by using Electronic Traded Funds or ETFs. ETF’s are a group of investments like stocks or bonds that are traded like stocks. For example, there’s an ETF that is like the S&P 500. You can buy one share of ticker SPY, for example, and be exposed to all of the S&P 500 companies. There’s ETFs for international stock or specific industries like technology or energy. These are a great way to hedge your portfolio against individual stocks.

There are also ETFs that are directional plays. For example, if you think the market is going to go down, you could buy what’s called an inverse ETF like SQQQ, which is basically betting that the Nasdaq is going down. These types of ETFs are more advanced and usually used for a short period of time. For example, if you felt like the market was going to keep going down in late February, you could buy one of these ETFs that would profit as the market goes down. But just remember, as the market goes up, these funds lose money.

ETF’s allow you to place money into strategic areas of the market since there is just about an ETF for any industry or theme that you can think of, and since they trade like stocks, you can get in and out throughout the trading day.

Options

The last method that I want to mention about hedging your portfolio is using something called Options. This is an advanced form of protection that some mutual funds, ETFs, and individuals use. It’s also a way to use leverage for profit and not just a hedge.

An option gives the holder of that option the right to buy or sell a certain amount of an underlying asset such as stock, like Microsoft or Amazon, at a specified price over a period of time.

One of the main advantages of an option is the built-in leverage that they offer. They allow you to profit by investing a small amount of money rather than buying the stock outright.

The two main types of options are called Puts and Calls. If you buy a Put, you are assuming the market will go down. The option gives you the right to sell the underlying. If you buy a call, you are assuming it will go up and, thus, the right to buy the security at the price of your option.

This could be used when you have a large profit on an individual stock, and you wanted to have some protection if the stock went down. You could buy a Put on that stock to reduce some of your downside risk.

In addition to buying puts and calls, you can also sell options as well. Since options are a contract, there are buyers, and there are sellers. The sellers collect the premium that is paid by the buyer for the contract. Many sellers use this as an income-generating strategy since most options that are bought are not exercised and expire worthless.

Options are an advanced investment strategy, and this is not something you step into after watching some guru’s video of how he made a zillion dollars by trading options. It’s a complex instrument that can cost you lots of money if you don’t have the knowledge or work with someone that does. There are many strategies that you can use with options, but you need to understand the risk, reward, and how to protect yourself.

Final Thoughts

Hopefully, that has given you some things to think about when it comes to your investments. This has been a crazy time with the virus and unprecedented moves in the market. This is why it’s important to have a plan in place, so you don’t make investment decisions based on emotion. This is why I think it’s critical to have someone as your guide to talk through the ups and downs of the market, but also through other life-changing events.

If you need some help implementing a portfolio that is right for you, or you want to explore how to reduce your risk, then head on over to agile finance radio.com and select the work with me option. We’ll have a 15-20 minute strategy call and then see if it makes sense for us to work together.

That does it for this episode of Agile Finance Radio. Tune in next time as we discover more ways to win with money, gain at life, and ultimately retire with confidence.