Risk Mitigation Enables Greater Risk-Adjusted Return
Risk management has become a ubiquitous sub-field in the financial world, but it wasn’t always the case. If there are dark clouds outside and you never go outside because you’re afraid of getting wet, then you’ve likely already failed in your investment strategy.
If you look far enough, there will always be ominous clouds on the horizon, so you have to bring an umbrella with you if you wish to operate effectively and stay dry in the world. The umbrella is a metaphor for the utility of a hedge. If you’re wearing an expensive suit, then an umbrella is definitely worth the investment, isn’t it? This everyday logic is at the root of risk management and mitigating your risk despite the field’s prohibitive jargon.
If you have better peace of mind and you’re less worried about career-ending catastrophic losses, then you’ll probably be a better investor. There will be many people trying to sell you different hedges, and you need to be able to determine whether or not that hedge is effective? How do we do this?
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Well, one key thing to pay attention is the correlation of the asset you are trying to hedge with the instrument you’re trying to hedge with. There can be direct instruments, like inverse ETFs, that will try to have a precise -1 correlation with the asset you’re trying to hedge. There are also leveraged ETFs with a -2 or -3 correlation to the investment you’re trying to hedge. While this may be what the vendor is selling, always be sure to check the correlations and historical data yourself, mainly if you’re using cross-asset hedging.
An example of cross-asset hedging would be the way many “Gold Bugs” have used their favored asset over the years. Those who lack faith in government, particularly those who lived through the Depression, always had a great affinity for gold because they saw it as separate from the machinations of what some would describe as the unstoppable fiscal expansion of the US government. In other words, Gold is not directly correlated to US currency.
Still, as a commodity that is bought to hedge against inflation, the correlation itself to events that weaken the dollar almost becomes a self-fulfilling prophecy. Using gold to hedge against a constellation of tail risks is an example of cross-asset hedging. Using an inverse SPY ETF to hedge a position on the
long side of the index would be an example of direct hedging. In other words, the ETF is specifically designed to be a precise instrument specifically designed to mitigate risk in a particular asset.
We’re much bigger fans of crypto these days. While the crypto doesn’t have definitive correlations, the fact that it is uncorrelated to significant risk assets is in itself a helpful characteristic for an investment. Why? Because when there is market panic and sell-offs, the old saying is, all correlations go to 1. So, sometimes in market panics, assets that typically move in opposite directions may actually sync up. This is often why downside panics exaggerate economic losses and often bring assets below their inherent values.
Some folks may think hedging is too expensive, and sometimes it is. Don’t hedge just to hedge. Just as you seek out investments that appear cheaply priced, the same is true of your hedges. Too great an emphasis on perfect hedging and ensuring every situation is fully covered may begin to diminish the returns of the assets you’re hedging. How do you determine which contracts are better priced than others? Well, the Black-Scholes Model, of course. This will be the subject of our next educational guide, and we recommend reading it next month to build on the lessons from the guide.
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