The Biggest Challenge Investors Now Face

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The biggest challenge investors face going into 2021 is how to hedge against a market crash. To those who didn’t live – or trade – through 1987, 1997, 2000, or 2008, such a notion seems distinctly old fashioned. After all, with banks like JP Morgan calling for the S&P 500 to hit 4,400 next year, and moonshot stocks like Tesla, Airbnb and DoorDash herding day traders onto Robinhood, why worry? The market powered back from the March plunge, after all. The real risk, as many investors see it, is missing out on the next leg skyward.

Much of the financial press says the main threats to the market are the election aftermath and the vaccine, which it sees as mostly under control. It large ignores concerns like the parlous state of the economy, out-of-control corporate leverage, indiscriminate investor risk appetite, and inflation. Red flags like skyrocketing margin debt and a plunging put/call ratio are shrugged off. With the Greenspan Put now established as official government policy, risk is seen as a thing of the past. Until, as experienced traders like to say, it’s not.

The stock market is now in the grips of what Wall Street likes to call a “technical bid.” The market is driven solely by psychology, not fundamentals. There’s no earthly reason Tesla should be worth more than every other car company on the planet combined. There’s no reason earnings sinkhole Airbnb, which looked on the edge of extinction six months ago, should be worth $100 billion. There’s no reason to believe celebrity SPAC managers will suddenly stop trailing the indexes now that they’ve got billions to play with.

So when will people stop buying? Predicting that is a fool’s errand. The trick is to acknowledge that they might, and then come up with your own idea about how bad the ensuing rout could be. Then you can decide how much you want to protect yourself.

First, look at the concept of return. Business schools teach that return alone isn’t a useful indicator. You must look at risk adjusted return. This is easy enough – the return goes in the numerator and the risk measure in the denominator. That’s why, before the pandemic shot market logic to pieces, an investment grade bond paying 5 percent with a risk of 1 was seen as a better bet than a junk bond paying 10 percent with a risk of 4. The Fed’s interventions have reduced the denominator on practically all fixed income investments to 1. Investor exuberance has done the same thing to stocks.

The problem with that 1 in the stock market denominator is that it only exists in the heads of investors. The Fed is reluctant intervene by backstopping the stock market with asset purchases. To see what could happen if investors start thinking it’s a 2, or a 5, or a 10, take a page from the people who manage risk for a living. Basically, they calculate risk as a combination of the probability of loss and its severity. The worst-case severity of a market crash isn’t known, but you can look at the March rout, or the 2008 crash, for guidance.

Your estimate of the probability of a crash happening will determine what risk managers call your hedge ratio – how much of your portfolio it makes sense to protect. At one extreme, if you’re sure the market will plummet, you should hedge it all by going to cash. If not, you’ve got some decisions to make.

First, you need to know how expensive it is to hedge your portfolio. If you go to cash, the cost is measured in the opportunity cost of lost gains if the market moves up. If you use puts, the cost is the premium, plus the time and attention you need to spend establishing and watching those positions. Puts are also time constrained – the market might not crash on schedule for you. If you buy short-term puts, and the market doesn’t crash soon enough, you lose your premium and run the risk that buying more puts to reestablish your hedge will be more expensive. A more straightforward, cheaper and automatic approach is to use trailing stop orders. They allow you to continue to capture gains on the upside, but bail you out when the market reverses. They’re also free.

The cost of hedging your entire portfolio, say, by buying a load of puts, can be eye-popping. So the next step is to determine what your worst-case losses could be. Then you can decide how much you want to reduce these, and how much it will cost you. If you don’t plan to retire for 30 years, your hedge ratio might be quite small – spending just a little on hedging and preserving just enough gains to ensure you can pay your bills for the foreseeable future. If you are retired right now, it might make sense to take the money and run.

Estimating the probability of a crash, and its potential severity, is an exercise in psychology, influenced by hope, herding, history and a host of other semi-rational factors. But if the past is any guide, now is a good time to start.

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About the Author

The Biggest Challenge Investors Now Face

Dwight Cass

Dwight Cass is a contributor to Investors Prism and financial journalist and editor specializing in risk management and capital markets. He has served as the Editor of Risk magazine and the Editor-in-Chief of Worth magazine, and has written financial commentary for The Wall Street Journal, the New York Times and others.