August 19th, 2010 16:47 EST
The Basics of Investment Hedging
Most people enter the investment arena thinking that "Risk" is a board game they played in college. Today, I would guess that the majority of investors have never owned an individual share of common stock or a Municipal Bond.
The popularity of investment products has heightened the risk for all investors and has indirectly led to many of the policy errors that threaten both capitalism and the economic fabric of America. Individual equity market prices are increasingly and inappropriately influenced by decision-making based only on the derivatives that contain them.
Few people consider the investment risk associated with public policy decisions. Product investors and derivative speculators participate in less personal markets, where it is more difficult to connect the dots between their personal financial interests and their political alignments.
So in a very real sense, investors have to deal with public policy risk every bit as much as they need to analyze the risks associated with the securities and other financial products they hold in their portfolios --- complicated, but it is doable.
Apart from these important peripheral considerations, the risk of loss in any equity investment is generally greater than the risk of loss in any debt related instrument. The potential reward from each type is just the opposite, and that`s where all the excitement begins.
Do we risk more for the chance of a greater return, or do we risk less and try to preserve our investment capital? Keeping in mind that investment capital is a measure of cost, not of market value, and that the only real loss is a realized loss.
Typically, the older the investor, the more boring or income focused the portfolio should be --- minimizing the overall level of risk. But it`s difficult to actively minimize or manage your risk in the "open end" mutual fund or passively managed ETF marketplace.
Risk minimization requires the identification of what`s inside a portfolio. Risk control requires decision-making by the owner of the investment assets. Risk management requires a selection process from a universe of securities that meet a known set of qualitative standards.
Product owners assume the added "fear and greed" risk of the general population, while their fund mangers stand aside and mumble about the opportunities lost in either direction.
Without a risk sensitive menu to select from, 401(k) participants need to minimize risk by: (a) avoiding the poor diversification that may be a requirement of their plan, and (b) developing outside income portfolios with any investable income above the employer matching contribution.
The first and most important management action focused on risk minimization in any "program" is the development of an asset allocation plan. The plan separates "liquid" investment assets into two buckets (Equity and Income) based on cost, not market value. No portfolio should have less than 30% in the income bucket --- no ifs, ands, or buts.
And no investment plan should be developed "tax" or "cost" first. Risk minimization comes first, and then tax minimization if possible. Finally, transaction cost minimization can be considered if you are qualified to run your program yourself.
A cost based asset allocation approach (Working Capital Model) assures growing levels of "base income" throughout the portfolio development process and, possibly, into retirement. Income growth, by the way, is the only real hedge against that other economic risk, inflation --- a buying power problem that has nothing to do with the market value of the income producing assets.
Minimizing investment risk is done best through the use of disciplined sets of rules for the various operations involved in managing a portfolio. Strict rules need to be developed for security selection, three types of diversification, income production, and for profit taking.
Forget the Wall Street "I-can-fix-that" product menagerie. We`re not interested in massaging our market value to take the sting out of cyclical market value changes. Our plan is to take advantage of these changes as they unwind around us over time, and when they occur unexpectedly, causing short-term disruptions and dislocations.
In the securities markets (stocks and bonds), the real risk of loss can be minimized without products and futures speculations, without commodities and hedge funds, and without the ageda that most people experience throughout their investment lifetimes.
The old fashioned principles of investing: Quality, Diversification, and Income, plus disciplined, targeted, Profit Taking are the only hedges an investment portfolio needs to assure long-term success. Conveniently, the QDI+PT applies equally well to both classes of investment securities.
"Q" is for quality. If you study the long-term behavior of Investment Grade Value Stocks, and high quality income CEFs, you`ll discover that they hedge themselves quite effectively.
Risk is wrung out of portfolios by investing only in S & P, B+ or better rated, dividend paying, and historically profitable companies and then only when their equity prices are well below their 52-week highs.
"D" is for diversification. Absolutely never allow any position in your portfolio to exceed 5% of total portfolio working capital (i.e., the total cost basis) and never start a position anywhere near maximum exposure. You want to be able to buy more at lower prices.
Similar diversification rules apply to industry exposure and global diversification through the use of the mainly world class companies in the investment grade quality categories.
"I" is for income. Own no security that does not pay regular, dependable, dividends or interest. Regular and growing dividends are a quality indicator in equities. In the income "bucket", seek out above average yields while avoiding those that seem either too high or two low.
Managed closed end funds do it best and provide easy "PT" and "buy more" opportunities. Buy established CEFs with long term "income" (not ROC) payment records.
"PT" is for profit taking. Absolutely always smile and take your profits willingly, net/net 7% to 10% (dependent upon available reinvestment possibilities and security class), and never, ever, look back.
Trading this same body of securities, again and again, has been shown to sustain growth of capital and income consistently in a relatively low risk environment.
Google Part III: Ten Time Tested Risk Minimization Strategies
Author of: "The Brainwashing of the American Investor: The Book that Wall Street Does Not Want YOU to Read", and "A Millionaire`s Secret Investment Strategy"