Why I've stopped 'hedging' my portfolio

Key Concepts

• Hedging: A risk management strategy used to offset potential losses in an investment by taking an opposite position in a related asset.
• Put Options: Financial contracts that give the owner the right, but not the obligation, to sell an asset at a specified price within a specific timeframe; used to profit from a decline in price.
• Shorting (Short Selling): An investment strategy where an investor borrows shares and sells them, hoping to buy them back later at a lower price to profit from the decline.
• Inverse ETFs: Exchange-traded funds designed to perform as the inverse of a specific index or benchmark; they increase in value when the underlying index falls.

The Economics of Hedging

The speaker addresses the common inquiry regarding why he chooses not to hedge his portfolio during market corrections or bear markets. He defines hedging as a form of "insurance" against market downturns, achieved through instruments like put options, short selling, or inverse ETFs.

The Argument Against Hedging

The core argument presented is that hedging is not free and, in the long run, acts as a drag on overall portfolio performance. The speaker provides a probabilistic assessment of the strategy:

• The Success Rate: He estimates that hedging is successful only about one out of five times (20%), where the market drops significantly, allowing the hedge to generate a profit.
• The Failure Rate: In four out of five times (80%), the market reverses and trends upward shortly after the hedge is initiated. In these instances, the cost of the put options or the losses from short positions erode the investor's capital.

Conclusion and Takeaway

The speaker concludes that while hedging may provide psychological comfort during periods of volatility, the mathematical reality is that it reduces long-term returns. By consistently paying for "insurance" that fails to pay out 80% of the time, an investor ultimately diminishes their total gains. Consequently, the speaker has moved away from hedging as a standard practice in his investment methodology, favoring a long-term perspective over the costs associated with market timing and protection.