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How to Avoid Hedging Pitfalls

Jason Stipp
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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Stipp: It's not just necessarily thinking about protecting something, but also as you were saying before, sometimes that insurance is much cheaper, sometimes it's much more expensive. So [investors should] kind of think of it more broadly as an investment versus just solely insurance.

Kobayashi-Solomon: Exactly.

Stipp: Erik, what kinds of instruments can you use to hedge? You are obviously the editor of OptionInvestor, so I assume that you can talk about options, but there are other sorts of investments out there, such as inverse investments, et cetera, that people might think of as hedges also. What [can you] make of all these different choices for hedging?

Kobayashi-Solomon: I am really glad you asked about inverse exchange-traded funds. They are weapons of financial mass destruction. Anyone who is watching this should definitely stay clear of those. My colleague Paul Justice who writes about ETFs actually wrote a terrific article about why you should not use inverse ETFs to try to hedge. 

Just aside from that, there are different vehicles that you can use to hedge, all of them have kind of weak points and strong points. I frankly think that for a variety of reasons, options are actually kind of the cheapest and easiest way for people to hedge who are not institutional investors. The explicit costs are a little bit higher, but there's not a lot of kind of worry or logistical things that you have to keep up with like you do with shorting stocks, for instance.

Stipp: What would be an example of using an option to hedge a certain kind of position? Can you just walk through if you wanted to hedge X, you would take a look at Y?

Kobayashi-Solomon: Let's say that you have a diversified stock portfolio. You think that there's a good chance of the market coming down some, and so you allocate some percentage, let's say 2%, of your portfolio toward buying protective puts on the S&P 500 Index. There's actually the SPDR ETF that has a liquid and deep option market on it that can be used very easily for that [purpose].

Stipp: And how do you know if that insurance, so to speak, is expensive or cheap? How can you gauge that? That would be obviously part of your decision in making that call, right?

Kobayashi-Solomon: Right. You know, I like to think about it just in common-sense terms. I've got a house that's worth $100,000. Do I want to pay $20,000 a year to insure that house? Obviously not. I mean, it does take a little while to kind of understand what the pricing looks like on options, but in general, remember that any money that you spend on a hedge is money that's going to be taken away from your own winnings at the end of the year.

Stipp: Erik, you mentioned before on the OptionInvestor website, you have some tools that can help investors think through some of these things. What are some of the explicit tools and resources that you have there that they can take a look at?

Kobayashi-Solomon: I've got a three-part series on hedging. I've got numerous spreadsheets and reader Q&A articles that talk about how to go through a hedge and think about how to hedge a portfolio.

Stipp: For OptionInvestor, we have a 14-day free trial membership. Folks can sign up for that and take a look at some of the more detailed descriptions of these hedging strategies. Erik thanks for joining me today and giving us the overview.

Kobayashi-Solomon: Thanks so much.

Stipp: From Morningstar, I am Jason Stipp. Thanks for watching.