In Seth Klarman’s Book Margin of Safety he provides some great examples of how investors can hedge their portfolios, depending on what they’re currently holding. Here’s an excerpt from the book:
Market risk—the risk that the overall stock market could decline—cannot be reduced through diversification but can be limited by hedging. An investor’s choice among many possible hedging strategies depends on the nature of his or her underlying holdings.
A diversified portfolio of large capitalization stocks, for example, could be effectively hedged through the sale of an appropriate quantity of Standard & Poor’s 500 index futures. This strategy would effectively eliminate both profits and losses due to broad-based stock market fluctuations. If a portfolio were hedged through the sale of index futures, investment success would thereafter depend on the performance of one’s holdings compared with the market as a whole.
A portfolio of interest-rate-sensitive stocks could be hedged by selling interest rate futures or purchasing or selling appropriate interest rate options. A gold-mining stock portfolio could be hedged against fluctuations in the price of gold by selling gold futures. A portfolio of import- or export-sensitive stocks could be partially hedged through appropriate transactions in the foreign exchange markets.
It is not always smart to hedge. When the available return is sufficient, for example, investors should be willing to incur risk and remain unhedged. Hedges can be expensive to buy and time-consuming to maintain, and overpaying for a hedge is as poor an idea as overpaying for an investment. When the cost is reasonable, however, a hedging strategy may allow investors to take advantage of an opportunity that otherwise would be excessively risky. In the best of all worlds, an investment that has valuable hedging properties may also be an attractive investment on its own merits.
By way of example, from mid-1988 to early 1990 the Japanese stock market rose repeatedly to record high levels. The market’s valuation appeared excessive by U.S. valuation criteria, but in Japan the view that the stock market was indirectly controlled by the government and would not necessarily be constrained by underlying fundamentals was widely held.
Japanese financial institutions, which had become accustomed to receiving large and growing annual inflows of funds for investment, were so confident that the market would continue to rise that they were willing to sell Japanese stock market puts (options to sell) at very low prices. To them sale of the puts generated immediate income; since in their view the market was almost certainly headed higher, the puts they sold would expire worthless. If the market should temporarily dip, they were confident that the shares being put back to them would easily be paid for out of the massive cash inflows they had come to expect.
Wall Street brokerage firms acted as intermediaries, originating these put options in Japan and selling them in private transactions to U.S. investors? These inexpensive puts were in theory an attractive, if imprecise, hedge for any stock portfolio. Since the Japanese stock market was considerably overvalued compared with the U.S. market, investors in U.S. equities could hedge the risk of a decline in their domestic holdings through the purchase of Japanese stock market puts. These puts were much less expensive than puts on the U.S. market, while offering considerably more upside potential if the Japanese market declined to historic valuation levels.
As it turned out, by mid-1990 the Japanese stock market had plunged 40 percent in value from the levels it had reached only a few months earlier. Holders of Japanese stock market put options, depending on the specific terms of their contracts, earned many times their original investment. Ironically, these Japanese puts did not prove to be a necessary hedge; the Japanese stock market decline was not accompanied by a material drop in U.S. share prices. These puts were simply a good investment that might have served as a hedge under other circumstances.
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