How To Hedge Your Portfolio Against A Market Turn

Reviewed: March 31, 2015
By FinanceWeb

Hedging for market corrections is not only a skill, but it is an expression of confidence. Rallies, no matter how deep and long they may run, eventually come to an end. In the corrections, many portfolios can lose substantial value. The key is to hedge against the corrections but to do so during the rally, and not just in reaction to a falling market.

Inaction Is A Poor Choice

Investor confidence requires that one can sometimes turn away from following a successful direction and plan for the eventual changes in the market. Many investors insist on inaction because it is easy, and it probably has worked before during the lengthy rallies. The market has been on the rise since 2009, when there have been short downturns. Many investors simply rode them out and stayed their prior course. When corrections occur it can have the impact on the entire market that the oil plunge had in the oil sector; it can substantially damage earnings and put goals like retirement and investment benchmarks in the balance.

Three Ways to Hedge Against A Correction

Hedging against corrections or a Bear Market can require some determination. One may have run against the direction most other investors take. The favorable strategies for hedging against a correction are to increase cash, reduce holdings, and shorten long holdings. The counter-cyclical strategy is use the increased cash holdings to strike opportunities.

Option One- Balance The Portfolio With Cash

Allocating a greater share of a successful portfolio to cash may seem like a losing proposition in a low bank interest environment. However, cash allocations are a tool against volatility. This cash allotment reduces the risk of loss immediately and provides flexibility for moves that can bring the investor closer to his or her long-term goals.

Option Two-Taking Profits

One simple maxim is that the only gains in the market are those that we take as profits. In a rising market, investors can become content to the point of complacency. This level of inaction is the lull that catches investors in the Bear Market storms. During a long run of rising markets, one can simply ask what level of loss will damage long term goals, and reduce holdings to that level through conversions to cash and profit-taking.

Option Three-Shorten Long Holdings

Using a systematic set of stop orders, one can reduce exposure by shortening long positions. This system is a good way to create cash and also to shift investments to shorter goals. One can convert equity holdings into income-oriented investments. Shift from developing long-term capital to more reliable dividends. This strategy is particularly effective in an active and expanding market.

Using Cash

Selling on the rise and buying on the fall is a logical method for maximizing the power and flexibility of cash holdings in a portfolio. When the market corrects, investor fears drive many good investments into panic sales. This wide-spread loss of investor confidence creates an opportunity that one’s cash flexibility can use to a major advantage. As the market falls, one can find undervalued stocks and begin to build for the counter cycle.

Hedging Against A Bear Market

At its core, hedging against a correction is a matter of actively planning a portfolio. The steps here are those which prudent investors can incorporate into their investment strategies. One should recognize the versatility of cash holdings, and that its relative disadvantage of not earning to the maximum is outweighed by the added power to move aggressively for opportunities. One should appreciate that rapid growth in any sector carries a potential for a correction; rapid rises hold as much potential for volatility as rapid declines, and one must always examine the underlying principles.