From Black Rain To Black Swans: The Importance Of Hedging
Below is a recording of my presentation to the Greensboro chapter of the American Association of Individual Investors on October 17th. Here is a summary of the topics including black rain and why to hedge in the presentation.
From Black Rain To Black Swans
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What Is And Isn’t A Hedge
A hedge is something that always rises in value when the underlying security you want to protect declines in value. That definition excludes assets some investors informally describe as hedges, such as gold. If you are long an individual stock that tumbles because it missed earnings, gold won’t protect you against that. Consider a current example, Intel (INTC) which fell after hours on Thursday after another earnings miss. Shares of the SPDR Gold Trust ETF (GLD) weren’t up after hours on Thursday. In contrast, put options on Intel will be up on Friday, if the stock opens significantly lower.
Why Consider Hedging Individual Stocks
I quote a JP Morgan Study which found that 40% of Russell 3000 stocks suffered catastrophic losses between 1980 and 2014. The study defined “catastrophic loss” as a decline of 70% or more without recovering. That study is no longer online, but I included screen shots of it here. I also discuss how much investors should consider paying to hedge.
Black Swans And Stock-Specific Risk
Black Swans can drive catastrophic losses in stocks. One example which occurred during the time period of the JP Morgan study was 2008 financial crisis. Gone are Lehman Brothers and a number of independent mortgage companies such as New Century Financial Corporation. Another example of a black swan has been the COVID-19 pandemic of 2020. COVID-19 lockdowns hammered shares of real estate investment trusts such as Simon Property Group (SPG). The COVID-19 black swan also drove gym owner Town Sports International (CLUB) to bankruptcy while boosting the fortunes of home fitness company Peloton (PTON).
Black Rain And Market Risk
Investors can ameliorate stock-specific risk with diversification and position sizing. However, diversification doesn’t protect against market risk. Although we’re accustomed to the market bouncing back quickly after a crash, that’s not always the case. Japan’s secular bear market has lasted so long that Nikkei 225 index now trades below where it did when the film Black Rain premiered in 1989. In the presentation, I discuss ways to hedge against stock-specific and market risk. I also discuss a way to maximize expected returns while hedging using Portfolio Armor.
There was a brief question and answer period at the end of the presentation. If you have a question that wasn’t asked there, feel free to leave it in the comments here and I will address it.
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Original Article Posted at : https://www.valuewalk.com/2020/10/black-rain-black-swans-hedging-importance/