One of the dictionary meanings of Hedge is to “limit or qualify something by conditions or exceptions”. In terms of investing, it is about limiting your risk by adopting strategies. Hedge funds (Smart money) employ complex strategies by employing algorithms and high power computing. Huge amounts of data are ingested by these algorithms and they find patterns in different market conditions. Based on these, algorithms are constructed and they carry out the trading. Just reading about these strategies may give you a headache. These are highly talented mathematicians, statisticians, data scientists applying their domain knowledge to investing.
But often it has been seen that many of these strategies backfire and most of the hedge funds are not able to beat the market. As a retail investor or any investor, you need to keep things simple. Focus on the fundamentals, understand the world around you, know what you know, more important know what you do not know and purchase any stock as if you are purchasing the business, keep a long term horizon and let compounding do the rest.
However, in this article, I would like to present a few simple strategies that you can employ as a retail investor wherein you could hedge your portfolio against major market contractions and in fact take advantage and make good returns. Please note that I do not short stocks and I don’t think it’s ethical to do that.
Hedge against competing companies
Whenever you evaluate the fundamentals and would like to purchase a stock, make sure you know who their close competitors are. Then invest 75% of your capital in your stock and the other 25% in your competitor’s stock. An example is two companies who manufacture hard drives, one is SeaGate technology (NASDAQ:STX) that uses old HDD technology and the other is teh Western Digital (NASDAQ:WDC) that uses the new Flash memory chips. There is a market for both of these, though the fear of the market is that old HDD technology goes away. So there may be a price discrepancy for STX. However you want to hedge against competition taking over, so you may purchase 75% of STX and 25% of WDC.
Hedge against sectors
The arrival of the electric cars is hugely anticipated and the stock of TESLA keeps hitting new highs every day. However all the traditional car companies are making huge investments in rolling out their electric models. So if you want to purchase TESLA, then you also make an investment in another traditional car company. On the same note, if you want to invest in the Oil sector, then a hedge would be to invest in Renewable energy.
Hedge against business models
The ever changing world and capitalism means any business that cannot keep up with the changing times will go bankrupt. Huge conglomerates have gone bankrupt because they could not keep up with the times. When you invest in a company, analyze its business model. Is it a low price model or an online model or physical model or hybrid model? Is it in a niche? Say you bought a low price offering company, purchase stock in a premium company as well. If you bought an online company, do hedge it with some stock in a physical company.
Hedge against natural calamities
With the onset of the COVID-19, the extent of damage to a portfolio can be seen. The retail sector, aviation, travel, restaurants is all taking a hit. On the other hand, delivery businesses, online collaboration platforms are flying high. When a natural disaster happens, communication is the key. All those companies that let you carry on your life to a minimal extent without you leaving home will be the ones in demand. All the businesses that need physical traffic will go down. Agreed this is a once a lifetime event, but when you allocate your portfolio, make sure you balance it out for these events as well.
Hedge against investor sentiment
At times, a company’s stock may be the darling of investors, shooting it all the way up. If you are tempted to join the bandwagon, study the fundamentals and the prospect of the business. If you think the euphoria is not justified but cannot resist, allocate a small portion of the portfolio and immediately put in a sell order for the daily moving average and also a stop loss. This way, you will automatically sell when it increases but will be hedged with a stop loss to get out of huge sellouts.
Conclusion
Finally the companies mentioned in this post are only examples and please do not treat them as stock recommendations. These simple strategies can save your portfolio from a permanent and total loss of capital, so you could come back in the game if you ever experience a severe decline in the market or the sectors that you have invested.