Summary A JP Morgan study found that 40% of stocks since 1980 have suffered “catastrophic losses”, meaning declines of 70% or more without recovering. Although JP Morgan calls for diversification in response, the statistic suggests diversification’s ability to ameliorate stock-specific risk is limited: what if 40% of your stocks suffer catastrophic losses? Hedging can prevent catastrophic losses, but its cost raises questions about when it makes sense to hedge. We offer two rules to clarify the tradeoffs and a sample hedged portfolio. Why Consider Hedging Why consider hedging securities at all? Why not just weather declines and wait for prices to recover? One answer is that often security prices never recover. According to a JP Morgan (NYSE: JPM ) report shared by Wall Street Journal reporter Morgan Housel (“Falling from grace: catastrophic losses in Russell 3000 prices”), since 1980, 40% of stocks have suffered permanent, catastrophic losses, meaning they fell at least 70%, and never recovered (Morgan Housel is pictured below; the illustration is from his Twitter (NYSE: TWTR ) profile page ). As the pull-quote below, taken from the JP Morgan report, notes, catastrophic losses aren’t confined to recessions; they happen all the time. The report goes on to note that different sectors suffer higher percentages of catastrophic losses at different times. For example, the oil price collapse of the early 1980s led to more than 40% of energy companies suffering catastrophic declines during that period, as the graph below from the report shows. Bear in mind that the graph above goes to the end of 2014. If the recent rout in oil continues, it’s possible we’ll see another spike in catastrophic loss rates for energy companies going forward. Hedging, Diversifying, or Holding Cash Given how common catastrophic losses in stocks have been, the first answer that may come to mind when considering when it makes sense to hedge is, “when you want to avoid catastrophic losses”, but that’s a bit too facile. After all, you can limit such losses without hedging: for example, by holding high levels of cash. Another way often mentioned to limit stock-specific risk without hedging individual holdings is to diversify; in fact, the JP Morgan report itself suggests this in the pull-quote below. If you’re confident that diversification can sufficiently limit your stock-specific risk, then you could simply diversify, and focus your risk management on ways to limit your market risk, which diversifiction doesn’t ameliorate. We discussed ways to do that in a previous article, How To Limit Your Market Risk . But, after having read the JP Morgan paper, we’re left with this question: what happens if you’re diversified and 40% of your stocks suffer catastrophic losses? It would seem that diversification alone might not protect your portfolio against a decline you would find unacceptable. So, we’re back to considering hedging individual positions, or holding cash. Holding Cash as an Alternative to Hedging Holding cash has the advantages of being simple, and cost-free (not counting opportunity cost). If, for example, the maximum drawdown you’re willing to risk is 10%, and you have 90% of your money in cash, then if everything you own with the other 10% suffers catastrophic losses, in the worst case scenario, your portfolio won’t be down more than 10%. Seeking Alpha contributor William Koldus, CFA, CAIA suggested a 90% cash portfolio in a recent article (“Why A 90% Cash Portfolio Will Likely Outperform”), but investors seeking higher returns may not want to hold such a high cash position. For those investors, a portfolio where each position is hedged may be preferable, so we’ll look at a couple of rules to guide their hedging and security selection decisions in constructing such a portfolio. Then, we’ll offer a sample hedged portfolio. These rules may seem obvious in hindsight, but could prove to be useful additions to your ” latticework of mental models “. Rule #1: Count The Cost Of Hedging Recall the example we mentioned above of an investor unwilling to risk a drawdown of more than 10%. We’ll refer to that 10% as his decline “threshold”. Let’s say that investor was using put options to hedge. Put options, for those who may benefit from a refresher, are contracts that give an investor the right to sell a security for a specified price (the strike price) before a specified date (the expiration date), regardless of where the market price of the security is at that time. For example, if you have a put option with a strike price of $10, and the price of your underlying stock drops to less than $5, you can still sell your stock for $10 per share.* Given the time frame over which he was looking to hedge, our hypothetical investor would want to find the put options that would protect him against a greater-than-10% decline at the lowest cost. When doing so, he’d need to take into account the cost of the hedge as it applies to his threshold: for example, let’s say there was a put option with a strike price 10% below the current market price of his stock, but it would cost 5% of his position value to buy it. If he bought that bought option, he’d actually be risking a 15% drawdown, taking into account the cost of the hedge. If the investor were using Portfolio Armor’s hedging app to find the optimal puts for a 10% threshold, the app would do this automatically, so, in the worst case scenario, the market value of the investor’s underlying stock, plus its hedge (minus the initial cost of the hedge) would total no less than 90% of the starting market value of his underlying stock position. The cost of hedging can also be used as a way to screen out some potentially bad investments, as we elaborated on in a recent article, 2 Screens To Avoid Bad Investments . Rule #2: Potential Return Must Exceed Hedging Cost Potential return here refers to an estimate of how well the security will perform over the time frame of the hedge. Let’s say that time frame is 6 months, and your threshold remains 10%, that is, you are unwilling to risk a drawdown of more than 10% over 6 months. And let’s you found a hedge that will limit the decline in your underling security to no more than 6%, and the hedge costs 4%, so it fulfills Rule #1 (you won’t be down more than your threshold, 10%, in a worst case scenario). So far, so good. But what if you estimate your underlying security has a potential return of 2% over the next six months? Then this hedged position fails Rule #2, because the potential return is less than the hedging cost: you’re potential return, net of hedging cost (your net potential return) in this case would be -2%. At a minimum, you would want your net potential return to be positive, but, ideally, you’d want to assemble a portfolio of hedged positions where the net potential returns are as high as possible, given your threshold (all else equal, the larger your threshold, i.e., the larger the drawdown you are willing to risk, the cheaper it will be to hedge, and the cheaper it is to hedge, the higher your net potential returns will be). Putting It All Together To implement this approach, for every security in your universe, you’d want to calculate the cost of hedging it against your decline threshold, eliminating all that are too expensive to hedge in that manner. Then you’d want to estimate potential returns for all of the securities that weren’t too expensive to hedge, and subtract the hedging costs from your potential return estimates, to get net potential returns. Then, you’d rank the securities by net potential return, and buy and hedge round lots (numbers of shares divisible by 100) of a handful of the ones with the highest net potential returns. That’s essentially what Portfolio Armor’s hedged portfolio construction tool does, though it adds an additional fine-tuning step. After rounding down dollar amounts to allocate to round lots of a handful of securities with the highest net potential returns in its universe (which consists of every optionable stock and exchange traded product in the US), it searches for what we call a “cash substitute”: that’s a security collared with a tight cap (1% or the current yield on a leading money market fund, whichever is higher) in an attempt to capture a better-than-cash return while keeping the investor’s downside limited according to his specifications. You could use a similar approach, or you could simply allocate left over cash to one of the securities you selected in the previous step. A Sample Hedged Portfolio Below is a hedged portfolio designed for an investor with $500,000 to invest who is unwilling to risk a drawdown of more than 10% over the next 6 months. This hedged portfolio was generated by Portfolio Armor using data as of Monday’s close. Why Those Particular Securities? After it applied its “2 screens to avoid bad investments” to its universe, eliminating inauspicious ones, the site sorted the remaining securities by potential return, net of hedging costs, or net potential return. It included Amazon (NASDAQ: AMZN ), Activision Blizzard (NASDAQ: ATVI ), Ctrip (NASDAQ: CTRP ), NVIDIA (NASDAQ: NVDA ), and Public Storage (NYSE: PSA ), because those had the highest net potential returns when hedged against > 10% declines. In its fine-tuning step, it added Regeneron Pharmaceuticals (NASDAQ: REGN ) as a cash substitute, because it had one of the highest net potential returns when hedged as one. Let’s turn our attention now to the portfolio level summary. Worst-Case Scenario The “Max Drawdown” column in the portfolio level summary shows the worst-case scenario for this hedged portfolio. If every underlying security in it went to zero before the hedges expired, the portfolio would decline 8.6%. Per Rule #1, that 8.6% maximum drawdown is inclusive of the 3.1% hedging cost, i.e., the portfolio value would only be down 5.5% not including the hedging cost, in a worst case scenario. Best-Case Scenario At the portfolio level, the net potential return is 12.74%. This represents the best-case scenario if each underlying security in the portfolio meets or exceeds its potential return. A More Likely Scenario The portfolio level expected return of 4.6% represents a more conservative estimate, based on the historical relationship between our calculated potential returns and actual returns. Each Security Is Hedged Note that in the portfolio above, each underlying security is hedged. Public Storage is hedged with an optimal put; Regeneron is hedged as a cash substitute, with an optimal collar with its cap set at 1%; and the rest of the securities are hedged with optimal collars with their caps set at their potential returns. Here’s a closer look at the hedge for Public Storage: As you can see in the screen capture above (image via the Portfolio Armor iOS app ), the cost of the PSA hedge was $2,280, or 4.55% of position value. To be conservative, the cost here was calculated using the ask price of the puts. In practice, an investor can often buy puts for less (at some price between the bid and ask), so the actual cost to purchase these puts would likely have been less. The cost of the other hedges in the portfolio was calculated in a similarly conservative manner. —————————————————————————– *Using a put option to sell an underlying security at the strike price is called “exercising” the option. In practice, you can often get the same level of protection, or better, by selling your underling security and your put option at their respective market prices than by exercising your put option. Depending on how far out the expiration date of your put option is (how much “time value” it has, in options terminology), the put option will trade for at least its “intrinsic value”, which is the difference between the option’s strike price ($10, in our example above) and the market price of the stock ($5, in the same example). So the option will trade for at least $5 in this scenario. But it may trade for more, if options market participants believe the underlying security may drop further (increasing the intrinsic value of the option) before the option expires.