How to Hedge Your Bets

Concerned about the market? Build yourself an insurance policy against future disaster.

By James K. Glassman, Contributing Editor

From Kiplinger's Personal Finance magazine, July 2009

After the past year's drubbing, many investors are finding little solace in historical trends.

True, the stock market has always recovered and stocks have always been the best place to put your money over the long term. But older investors don't have much long term left. They want to retire and draw on their assets, and they can't take the chance that shares will again lose 55% of their value, as Standard & Poor's 500-stock index did between October 2007 and March 2009.

Plus, for some investors with a longer time frame, the experience of the past year has been just too horrifying. They don't want to go through it again.

For a third group, all the talk about financial history isn't persuasive. The U.S. economy -- not to mention the global economy that helps mold it -- is different today than it was in the 1950s and the '80s. With giant banks, $3-trillion federal budgets, new powerhouses such as China, India and Brazil, and huge debt burdens, we are in uncharted waters.

Antidote to calamity

These are all legitimate concerns, and they can be addressed in the same way: by building hedges against the possibility of future disaster. A hedge is an insurance policy. In some cases, it requires a direct premium; in others, it means a reduction in your gains when markets rise (which amounts to the same thing).

Hedge has become a confusing word in finance because many institutions that are called hedge funds don't hedge at all. Instead, they make large bets that a few assets (such as the euro or the debt of U.S. carmakers) will move up in value.

We could all use a financial hedge because the rest of our lives are so closely tied to the economy. Our jobs, the value of our houses, our ability to repay debt, our retirement savings, our health care -- for all of these, we take the position of being long on the economy. That is, we prosper when gross domestic product rises and unemployment falls. It's impossible to short your job (that is, win when you lose it) and impractical to short your house (which would mean selling it, moving into a rental, and buying it back when home prices fall).

But you can order your financial life so that you can gain -- or at least not lose so much -- when markets fall. The easiest method is to reallocate what you own in your portfolio to trade the potential for larger profits for lower risk.

As long as your investments are sensibly diversified, asset allocation, rather than your choice of particular stocks or bonds, is the most important determinant of financial performance.

The younger you are, the more stocks you should own. Stocks return more than bonds or cash in the long term, but stocks are more apt to lose value in the short term. If you are young, you can ride out the tough times.

But if you are on the verge of retirement and you have the overwhelming majority of your assets in stocks, a 40% decline in share prices would be devastating.

There are no hard-and-fast rules, but the Iowa Public Employees' Retirement System has devised a handy online calculator that churns out allocation suggestions based on age, risk aversion and a few other factors. For example, if you're about 40 years old with average risk tolerance, $400,000 in retirement assets and savings of $10,000 a year, the calculator advises 74% stocks, 14% bonds and 12% cash.

That sounds right for the stock market that prevailed in the 20th century. But what about the 21st? To protect yourself against future calamities, you may want to allocate less to stocks and more to bonds and cash.

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