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How to hedge or insure your stock portfolio

Tuesday, May 17th, 2016

Investors are starting to worry what the stock market may do over the next five months until we have a new president.

At my investment firm, Wilsey Asset Management, we always talk about buying small pieces of large companies and holding them for the longer term.

But even with that said, I understand how people see the stock market and when declines begin to happen, the media will bring it to everyone's attention just to scare everyone.

I also agree that the stock market, as measured by the S & P 500 Index, is a bit pricey because it is a market cap weighted index and there are many large companies trading at excessively high valuations.

If you watch/read our daily posts, when we discuss our “stock of the day” you can see many companies are trading at high valuations. When valuations are too high, the markets can have a pullback.

Initially this can hit stocks across the board, with the higher valuation companies taking the bigger hit than the lower valuation ones.

However, quickest to recovery has always been the more reasonably valued price-to-earnings ratio companies. This is why over the longer-term, value investing has outperformed growth investing.

There is an option for investors to provide some insurance, or a hedge, against market declines. They are known as inverse correlation funds. These are funds that move in the opposite direction of the index in which they are inverse to. The most common would include the Dow Jones industrial average, the S&P 500 and the NASDAQ. There are many more, but I would not recommend attempting to use these others.  

I caution you to only use these as a hedge, or insurance against declining markets. In the past I have seen people get so excited and convinced they are going to make a killing, because they know the stock market is going down. The risk of doing so is extremely high and I discourage anyone from playing that gambling game. Therefore I am recommending these only as a hedge.

An investor can either buy an open-end inverse correlation mutual fund or an ETF, which is an exchange traded fund.

I prefer the ETF over the mutual fund because they more or less do the same thing, since it is inverse to an index; however I find the ETF has lower fees.

Investors also need to look for the term "ultrashort," which means the ETF or mutual fund could move two or three times as much in the opposite direction as the index.

In other words; with a normal inverse correlation fund, if the index were to fall 10%, the inverse correlation fund would increase 10%. If you were to use an ultrashort fund and the index would fall 10%, your fund would increase 20%, or two times. I have seen these as high as three times and while there could be higher ones, I have not seen them.

The benefit of the ultrashort funds is, you can get a better hedge with less of an investment. But keep in mind, if the index were to go up 10% and you used an ultrashort fund, your hedge would go down 20%.

You may be wondering how these inverse correlation funds work. It would be wise to understand, so you don't panic when things don't go as expected. These funds work by using short selling, trading derivatives, (which include futures contracts) and perhaps other leveraged investment techniques.

As you can tell, it is very important one understands these inverse correlation funds because if not used properly, the risk could outweigh the reward. Lastly, I would not recommending using these types of funds for much longer than a six-month period.

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