How to Hedge Your Bets

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.

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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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Let's use the averages derived by Ibbotson Associates, a Morningstar company, from 1926 through March 31, 2009. Large-company stocks (represented by the S&P 500) returned 9.4% annually; intermediate-term U.S. Treasury bonds, 5.4%. Bond yields are far lower today and probably will remain low in the near future. Taking into account brokerage or mutual fund fees, let's assume stocks return 9% a year in the future and bonds gain 4%. So a $100,000 portfolio that is 90% stocks and 10% bonds will return about $8,500, or 8.5% annually.

Let's shift the allocation to 50% stocks and 50% bonds. The returns drop to $6,500, or 6.5% annually. Ibbotson finds that such an allocation drastically reduces volatility -- the risk that you will lose a lot of money in a relatively short time. The biggest one-year loss since 1926 for a 90% stock/10% bond portfolio was 40%, in 1931; the worst five-year performance, also during the Great Depression, produced an average annual loss of 10%. But with a 50-50 allocation, the worst one-year loss was 25%; the worst five-year loss, 3% annualized.

Of course, there's no guarantee that the future will be like the past. But ask yourself this: Are you willing to give up two percentage points over the long term (accepting a return of 6.5% a year rather than 8.5%) to drastically cut your chances of losing a lot of money in the short and medium term?

Inverse funds

Now let's turn to a more overt insurance policy: an exchange-traded fund that rises in value when stock prices fall. Consider ProShares Short S&P 500 (symbol SH). By using derivatives, the fund produces a return that is roughly the inverse of the S&P 500. For example, for the year that ended April 30, during which the S&P declined 35%, the fund rose 29% (part of the disparity comes from a 0.95% expense ratio and part from market forces, which don't work precisely in tandem with prices of the stocks that make up the S&P).

Again, if history is a guide, we can predict that in an average year, ProShares Short will lose about 10.4% (including expenses). But in a terrible year, the fund provides a cushion. Imagine you had bought an insurance policy at the start of 2008 by placing 10% of your assets in the fund. Say that your other allocations were 60% in stocks, 20% in Treasury bonds (yielding 3%), and 10% in cash, yielding 1%.

If you had started with $100,000, you would have finished the year with $81,500 (assuming bonds held their value). Without the hedge, a portfolio that was 70% stocks, 20% bonds and 10% cash would have ended with $74,100. (If the stock market had climbed 20% in 2008, the unhedged portfolio would have gained $14,700, while the one with ProShares Short would have added just $10,700.)

Options strategy

A third way to hedge is to buy put options. A put is a contract that gives you the right to sell a security at a set price -- known as a strike price -- during a set period. Consider a stock we'll call Green Motors, trading at $40 a share. You believe that Green is headed for a fall, so you purchase a put contract for $100 that lets you sell 100 shares of Green for $35 a share at any time over the next year.

Let's say that Green falls to $25 within six months. You exercise your option, which lets you put Green to another investor (that is, force him to buy it) at $35. You go into the market and buy 100 shares of Green at $25, immediately sell it at $35, and you receive $1,000 ($10 multiplied by 100 shares), minus your original $100 put investment, for a profit of $900.

All you really need to know about puts is that they make money when prices fall. You can accept different degrees of risk. In the example above, if Green dropped from $40 to $36 after a year, your puts would finish out of the money and expire worthless.

Now let's translate the investment to the broad market. At the close on May 8, S&P 500 puts with a strike price of 700 and an expiration of August were trading at $9. At the time, the index itself was at 909. These puts would give you protection against the market dropping about 23%. Let's say that by August, the S&P was down to 650. Contracts costing $9,000 would now be worth about $50,000, for a profit of $41,000 -- a good insurance benefit for the losses you suffered in the stock part of your portfolio.

But how much insurance do you need? The protection I describe above -- against a market drop of about one-fourth -- makes sense for about $500,000 worth of stock assets. So the cost of protection is roughly 2% of your portfolio. Say that the market drops 40%. Your losses without put insurance are $200,000. But with the insurance I am describing, the losses are cut to about $54,000.

Of course, if the S&P closes above 700 in August, you lose your entire put investment. That is, however, the nature of an insurance premium. In times like these, insurance -- through asset allocation, bear funds or puts -- appears well worth the price.

James K. Glassman, former Under Secretary of State, is president of the World Growth Institute.