Buy and Hedge, the 5 iron rules for investing over the long term

by Jay Pestrichelli & Wayne Ferbert
isbn: 978-0-13-282524-5
www.buyand hedge.com blog

notes:
capital lost is capital that cannot grow
risk is the input; return is the output
emotion is the enemy
volatility is kryptonite
return that matters is after tax return

hedge every investment
know your risk metrics
smart portfolio = long term outlook + diversification
unleash your innter guru
harvest gains and losses

3 strategies
indexing
asset class allocation
defensive hedging

gain from avoiding a loss is more than just the loss avoidance, it also benefits from compounded grown on capital preserved.

3 basic hedging tactics for your positions (sometime incorrectly called strategies)
married put (married call for short positions)
collar
in-the-money options (aka ITM calls or ITM puts

build a portfolio hedge

1. calculate your overall portfolio value and determine the net long or short value
2. find an investment that is an index product (such as an ETF) that has a high correlation to your portfolio and has options that trade on it. (Typically this is a broad market index for most investors, such as an S&P ETF)
3. buy the put protection (for net long portolios) or the call protection (for net short portfolios) that provides the downside protection the investor wants.

use delta to assess the extent you have hedged a position

4 key metrics

• capital at risk (CaR) maximum loss that could incur on an investment given the hedges put in place
• volatility- measure 1 year and 90 day
• implied leverage = (total market value of nonderivative securities + implied equity value for each derivatives position) / (total portfolio value - borrowed money)
• correlation - measures how 2 investments tend to move in price in relation to each other.

calculate portfolio volatility

1. gather closing portfolio liquidation value for every day the market was open in the trailing 12 months (about 252 data points)
2. calculate the percentage change in your portfolio each day. (adjust for any deposits or withdrawals each day)
3. of the resulting 252 percentage changes calculated, determine the standard deviation of the percentage changes
4. multiple  the standard deviation by the square root of 252 (15.87)

Steps for using correlation (6 month, 1 year and 3 year) to inform your risk decisions

• know correlation of each underlying investment in your portfolio to each other
• when adding a new investment to your portfolio, know the correlation of that investment to each investment already in your portfolio
• know the correlation of each position to the broader market. e.g. S&P 500 index
• http://www.sectorspdr.com/correlation/
• http://www.sectorspdr.com/sectortracker/
• http://www.sectorspdr.com/

 Rules for constructing a long-term portfolio

•  new investments should have expected hold time of more than 1 year
• portfolio should regularly have investment that have been held for 2 year or more. (often your broad market index investments)
• never invest with an intended hold time of less than 6 months

Base portfolio (when you hedge to reduce risk)

• Broad market indexes 70% (70-90%) recommend at least 50%, make sure that no more than 10% of your portfolio is ever concentrated in one sector
• Inner Guru investments 20% (range 0-10-40%)
• Cash 10%
• near retirement 10% to bond ETFs, then increase 10% each year until max out at 50%

ID your investing strengths - keep an investment journal
avoid being concentrated in one sector
review investments weekly

options

• are the preferred method of creating defensive hedges
• allow investors to define risk levels with a high degree of certainty (married put)
• are leveraged vehicles that allow hedges to be set without requiring a lare amount of capital
• can be sold for income to help fund the cost of hedges (a collar)
• are contract to take a buy/sell action at a predetermined price by a predetermined time on a defined asset.
• has 4 parts; underlying asset option is on, when option expires, strike price, whether it is a call or a put