Joshua Wilson has no fear or misunderstandings about how to use hedging strategies to build better portfolios, though he suspects many advisers do.
“You have to think of hedging like insurance,” said Wilson, who is a partner and the chief investment for WorthPointe in Austin, Texas.
He specializes in the use of options, hedging strategies and tactical investment strategies for individuals and institutions.
As is true with insurance, with hedging, a client should not expect higher returns but rather that if the stock market becomes volatile, they won’t lose as much, Wilson said.
But advisers and clients should recognize that, as with insurance, with hedging, prices rise when risks rise.
“If it starts at $100 a month for a 100-year flood insurance on a sunny day, and then there is news that a 100-year flood is coming to Texas, the premiums may rise to $1,000 a month. If the rains then are at the door, it may go up to $10,000 a month,” Wilson said about insurance costs.
Apply that analogy to hedging prices as concerns about market volatility rise and what happens?
“It can definitely get out of hand,” Wilson said.
The costs of hedging rise along with expectations that the market will become volatile, he said.
When recent news accounts made investors worry about market volatility, including stories questioning President Donald Trump’s abilities to pursue pro-growth policies and others about terrorist attacks, the price of hedging increased from previous weeks.
“People love the idea of protection, but they want to wait to until it’s obvious they need protection,” Wilson said.
At that point, hedging will be expensive, and advisers who want to help their clients hedge should not try and time the market.
No one possesses the “supreme ability to time the market,” Wilson said.
“Don’t try and time your hedging," he said.
Brent Everett, founder, chief investment officer and partner at Talis Advisors in Plano, Texas, draws the same conclusions.
“Our investment strategy is more strategic than tactical. Hedging what one may view as an overvalued asset class is essentially a market timing decision, and we know how well that has proven to work over time: not very,” Everett said.
He also noted hedging’s limitation.
“There is a cost associated with hedging that, over time, impacts performance,” Everett said.
Everett also stressed the distinctions between hedging and rebalancing.
“Generally, hedging and rebalancing are different issues,” he said. “Although, like hedging, rebalancing can help control the amount of risk that a portfolio is exposed to.”
But whether simply rebalancing or hedging, the goal for the portfolio remains clear.
“In the long term, risk and return are related, and we believe that clients should invest in a portfolio that’s designed to produce enough return to meet their goals while not exceeding their risk tolerance,” Everett said.
Miriam Rozen writes about the financial advisory industry and is a staff reporter for Law.com.
This story is part of a 30-30 series on building a better portfolio.