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By Jason Stipp and Erik Kobayashi-Solomon | 06-06-2012 10:00 AM

How to Avoid Hedging Pitfalls

Although hedging offers a form of portfolio insurance, investors often mistime the market and mistake asset-allocation woes as hedging problems, says Morningstar's Erik Kobayashi-Solomon.

Jason Stipp: I am Jason Stipp for Morningstar. As stock volatility continues, investors' minds naturally start to head toward hedging strategies. But just what is hedging, and how can you avoid some of the common mistakes that investors make with their hedging strategies? Here to offer some tips is Erik Kobayashi-Solomon. He is the editor of Morningstar OptionInvestor. Thanks for being here, Erik.

Erik Kobayashi-Solomon: Thanks for inviting me, Jason.

Stipp: Investors can get into a bit of trouble when they go out to hedge their portfolios. I do think when we see market volatility, when we see concerns out of Europe, systemic risk comes to people's minds. They want to find a way to protect their portfolios. Hedging is one way to do that, but there are also a lot of pitfalls. What are some of those pitfalls? How can we avoid them?

Kobayashi-Solomon: The number-one thing I am confronted with all the time is, imagine this: You are in a car on a slick road. It's late at night, and you start skidding toward a tree. It's then that you pull out your mobile phone and start calling your insurance broker to buy car insurance. It doesn't work. People start thinking about hedging, start thinking about financial insurance too late. Financial insurance is just like any other commodity; when the demand for it is high, the price is going to be very high.  A lot of people, when the market is going up, they want speculative ideas. And then when it's coming down, they want to figure out how to hedge. In both cases it's kind of too late by that point.

Stipp: If everyone called their insurance agent after their house was on fire, the cost of that insurance would probably be exorbitant.

Kobayashi-Solomon: It'd be incredible. That's right.

Stipp: What are some ways we can think about this besides just being proactive and thinking ahead of time, and not following the crowd necessarily and buying this at the last minute? What are some ways that we can avoid some of the other mistakes that people make and think about hedging more broadly in a portfolio?

Kobayashi-Solomon: One of the things that I think that a lot of people really make a mistake about is also perspective. You see this both in terms of overbetting and underbetting. You see a 63-year old man who is nearing retirement, who has 30% of his retirement savings in highly volatile oil-exploration companies, something like that, small-cap companies. Certainly, I think that a lot of hedging problems, things that people perceive as hedging problems, are actually more asset-allocation problems. If you are uncomfortable, if you are not being able to sleep at night because of some very large speculative bets, it's better to scale down the size of those bets and just do some common-sense portfolio-makeover kind of strategies. Another kind of class of problems is you see somebody my age who is fretting about 1% of their portfolio being volatile. At my age I've got plenty of time before retirement. I don't need to worry about that.

Stipp: It sort of sounds to me like you're saying is that not every portfolio necessarily needs an explicit hedging strategy to hedge specific investments. You might look at how you are allocated. Do you have enough liquid investments? Do you have enough less volatile investments to ride out rough times maybe for your more volatile investments? How do I know then if my portfolio is a good candidate? When should I hedge, explicitly hedge, with some instruments to basically counteract certain holdings that I have?

Kobayashi-Solomon: You know, a lot of people think about hedges like a safety blanket. I want to be safe. I want to feel good, and so I am going to put this hedge on. I really like to think about hedges as an investment, kind of a proactive investment. It has a lot to do with one's own personal risk tolerance. Actually on the Morningstar OptionInvestor's website I go into a lot of detail about how to think about a portfolio and how to place a hedge as a bet.

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