From: Tad Borek 
Newsgroups: misc.invest.financial-plan
Subject: Re: Hedging stock fund investments
Date: Mon, 23 Feb 2004 19:42:34 CST
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Nobody wrote:
> Can anyone suggest strategies for hedging my domestic stock positions?  
> I invest exclusively in mutual funds (Vanguard, TIAA-CREF).  From a risk 
> tolerance standpoint, my target allocation is 70% equity / 30% bonds.  I 
> also ladder CDs and use a money market for my emergency fund.
> 
> For bonds, I have stayed with short duration funds (vanguard short term 
> corporate) and TIPS, as I believe that interest rate hikes and inflation 
> are both likely near term risks.
> 
> What worries me at this point are stocks.  I am diversified across 
> market sectors and capitalizations, and I have a substantial 
> international position for diversification purposes too.

What ALWAYS worries people are the stocks!

In international, do you include small, value, and emerging markets? 
Some of the studies suggest those are better diversifyers than 
large-caps. Generally these all outperformed the US market last year, 
showing the value of diversifying overseas (finally! for some of these 
it's taken years...). Those concerned with job flow outside of the US 
might consider these as offsetting investments.

> I see, however, that Vanguard published a chart that shows how equity 
> valuations are climbing well outside of the historical mean as a 
> percentage of GDP. ... also, [insider selling, Bush's economic policies]
> In short, I believe that something's got to give in the next year.
> 
> Given all of this, are there hedging options for us little guys?  Or is 
> fleeing to cash the only option?  I should add that I don't expect to 
> need the funds invested for >10 years; however, that doesn't mean that I 
> feel comfortable sitting idly by while the alarm bells are ringing.

By definition a true hedge reduces both losses and gains, so it might 
not be what you're after.

You could diversify more, but it sounds like you may have diversified as 
much as feasible without adding oddities like gold or timber or pork 
bellies.

You could change your allocations...70/30 might just be too risky for 
you. Cash dampens out the volatility; value stocks add risk but could 
reduce losses that occur due to an overpriced market. Arguably any mix 
that has you revisiting things based on short-term news might be too 
risky. Current stock valuation vs. GDP, economic policies that probably 
won't be in place even a few years from now, insider selling...this 
isn't exactly long-term stuff. The fact it concerns you suggests 70/30 
isn't right, at least for a pure asset-allocation kind of strategy 
(which asks you to sit idly by despite the alarm bells - rebalancing 
periodically, but little more).

You could also give up a pure asset-allocation strategy, if that was 
ever even what you'd planned. Perhaps base your allocations on the 
relative valuations of the asset classes - there are dozens of these 
kinds of models. Keep in mind that when doing so you're introducing 
another risk element, "manager risk" (you're the manager). The fancy 
term for the technique is "tactical asset allocation" aka market timing. 
Much has been written about that...as I'm sure you know, the risk is 
that you'll sit on the sidelines at the wrong time.

One comment: I hear so often people saying "I'm a long-term investor 
but..." followed by considerations that span months or perhaps a couple 
of years. For truly long-term goals the expected levels of these 
different investments 15 years from now should be more of a concern than 
their relative valuations now, or 15 weeks from now. You can always find 
bearish signals but it would be unusual to say "this investment won't do 
much for me in the next 15 years." My personal view is that long-term 
bonds qualify for that kind of scorn, but everything else is solidly in 
the grey area.

Sure, lots of the alternatives look expensive. But arguably when 
everything looks overpriced it's a crap shoot to pull your money out of 
any of them.

Of course if you really feel the Big Drop coming on, cash is king. And 
if you're correct, a career in money management awaits!

-Tad