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A Simple Investing Plan For Tumultuous Times

Summary Equity markets have been, and still are, a fantastic source of wealth preservation and generation. This article presents an extremely simple, minimal effort investment plan, based on market ETFs, aimed at simply capturing market returns. The reasoning behind my approach is discussed, as are possible uses, advantages and disadvantages and some investing obstacles that need to be identified, but that can be avoided. Finally, I suggest some ways of moving away from the default plan presented and into additional investing strategies. If you are looking to time the market, buy on a dip, or buy gold, this article is not for you. The future is always uncertain. Price changes are nothing new, they are an inherent part of market behavior. However, price changes tend to stir up a lot of emotion, something that does not always lead to better investing decisions. In this article, I describe an extremely simple and minimal effort investing plan that can be used as a default strategy in tumultuous, bear or bull markets alike. The plan can be used by an investor getting started at managing their private portfolio, an investor not sure what to do with their savings, or an investor simply looking to spend minimal time on managing their savings. It is readily available to anyone, and can be used as a default plan throughout your investing life. As such, it can be used either to fall back on when needed, or as a benchmark to help assess your investment making decisions. The core idea of the plan is to buy an equity market ETF over time by purchasing at regularly spaced intervals. I discuss the reasoning behind such a strategy, possible advantages and disadvantages of such a plan, as well as some ways of developing it further. For many private investors, there should be no need to ever move to anything more complicated. Even so, I present some initial ways to customize it further and add in more elements, depending on the individual investor, and mainly to add interest. Background and Context Buying stock of a profitable company is different than buying other financial products. Stocks have the potential to create returns not derived solely from trading. It’s not a zero-sum game. If the company makes money, this income will hopefully make its way back to the investor through either dividends, or retained earnings leading to higher market price. For these reasons and more, stocks, as an asset class, have backwinds blowing in their favor that other financial contracts do not. For anyone able to save money over time, it is therefore extremely helpful to consider how the attractive qualities of stock ownership can be taken advantage of. Some companies will be more profitable than others. Some companies will either never become profitable to investors, or turn to losses over time. It can be surprisingly difficult and time consuming to sift through the over seventeen hundred public companies available to choose from on the NYSE/NASDAQ alone. Luckily, the advantageous features of equity investing can be easily taken advantage of using a broad equity market ETF. Recent market turmoil does not change any of this. It is part of market behavior, and always has been. It is said that a wise man accepts, while the fool insists. Price changes in the market, both up and down, should be accepted by anyone involved in purchasing stocks. Price fluctuations can be viewed as creating opportunity – we all want to buy low and sell high. There are two basic obstacles towards successfully doing so: (1) Obtaining a sound evaluation which allows to judge when prices are high, or when they are low, and (2) The psychological ability to be a contrarian; to sell when most others are eager to buy, and buy when most others are eager to sell. Both these obstacles require time and effort. At a personal level, they may require specific skills which may differ from one person to the next. Instead of looking to profit more from price fluctuations, another approach is to simply avoid making mistakes that may result from taking the wrong action in a changing environment. This is the minimal effort approach and is the one I will focus on for the duration of this article. The greatest risk is buying in at a very high price. Buying on multiple occasions ensures that even if one purchase is made at a bad (i.e. high) price, other purchases will soften the effect and provide better returns. Of course, this also means that you won’t buy in at an all-time low either. What you will get by buying on multiple occasions over time, is exactly what the plan is intended for – market returns. Market returns are underrated. They don’t produce the same excitement that a tech IPO does, but they are nothing to sneeze at. The table above shows the returns of the S&P 500 market index, including dividends, over the past two decades. Returns that an investor would receive from simply owning the index for ten years are stated as well. These figures refer to the ten years ending December 31st of the year stated in the left most column. Finally, annualized returns for the same ten-year period appear in the right most column. As you can see, over a longer period, returns are rarely negative, with only 2008 and 2009 showing negative ten-year cumulative returns over this period. As long as you are able to save money over time, the plan below does not include selling. This ensures that these losses would have remained on paper only (and the low prices at the time would have provided good buying prices). Buying during periods of very high market valuations (e.g. circa 2000) is not avoided completely by the plan. Instead, buying over multiple periods causes the buying prices to average out. The above purchasing behavior should therefore ensure the investor positive returns. The Basic Plan Buy only one security – the S&P 500 Index ETF. Time purchases using only a calendar. Make new purchases every 6 or 12 months. That’s it. Any broad market ETF will do. The SPDR S&P 500 Trust ETF SPY is the most popular, and I refer to it throughout this article, but there are other equivalent ETFs that should be just as good. If you are starting with a large chunk of money, you could split it up for your first 6 purchases at 6-month intervals. If you are able to save part of your income, simply use whatever you have saved over 6 months to buy more SPY. If you already have a portfolio with many positions, you can convert all or parts of it into SPY every time you make a sale. It should be simple to gradually convert any portfolio into SPY over time, regardless of the starting point. But is now a good time to buy? I discussed possible near future market valuations based on historic data in a previous article . The plan presented here is based on multiple acquisitions made at predetermined intervals. In that light, now is as good, or bad, a time to buy as any. It does not matter in regard to this investing approach. Advantages Of The Plan 1. You will spend virtually no time managing it. You do not need to read any news, any investing advice articles, or listen to any talking heads on TV. You definitely don’t need to know what is going on in the stock market, China, Greece, the Federal Reserve or any other media topic. 2. The costs of this plan are as close to nothing as you can get. The plan calls for 1-2 transactions a year. Using an online brokerage account will reduce costs significantly. In total, costs should not come out to be more than a few dollars for the entire year. These savings alone will add up more than you might expect. 3. Over time, you will outperform most other investment funds. It may sound odd, but it is a rather established result that most managed funds will produce lower returns to an investor than those received from passive market investing. For many managed funds, a key reason is fees. Many other reasons exist as well. For example, many funds diversify into additional asset classes other than stocks. Historically, stocks tend to outperform other asset classes. It should be no surprise, therefore, that a fund with (for example) only 50% equities will attain lesser gains when compared to a broad stock market index. Additionally, there is no reason that the distribution of money management skill should differ from that of any other skill. Skill or ability in any discipline has a long tail distribution (where the average is greater than the median). Most people show weak, or below average ability at any specific skill or discipline, while some show decent ability, and a small subgroup are exceptional. This type of distribution can be observed for throwing a football, dancing, mathematics, and it is true for managing money as well. Some funds will be managed by exceptional money managers, while most won’t. The hiring of money managers, and fund selection in general, if done with the goal of obtaining better returns, shares many similarities with stock selection. One cannot avoid in-depth analysis if interested in making a good choice. Often times, evaluation of money management skill is done based on historical performance. A manager or fund able to produce an easily reviewed exceptional long-term past record will also be able to demand much higher fees. This may again reduce returns to the investor. While the issue of fund selection is still much broader than discussed here, it is not the focus of this article. The plan presented is based on the fact that most funds will provide lesser results while identifying the ones that don’t requires additional effort. Disadvantages Of The Plan 1. It’s boring. This should be a non-issue since we are interested in making money, not having fun, right? Unfortunately, on a day-to-day basis, it can become an issue for some. This plan really is not much fun, and you will need to get your kicks outside of investing if you follow it. On the plus side, if you do follow it, you will be able to have a lot more fun thanks to the time it will free up, and the money down the road. In the meantime, if this is an issue, later in the article I will present some ways to make this plan a little more interesting as well as require more active involvement. 2. You don’t get to beat the market. Everyone wants to “beat the market” (author included). However, doing so requires a lot of time and effort. Also, sometimes overeagerly chasing greater returns can lead to worse performance, not better. It is surprisingly difficult to attain returns that are considerably better. Doing so either requires a considerable effort, or blind luck. The latter is usually short lived. The basic plan presented aims to take advantage of the attractiveness of market returns. Nothing more, and hopefully, nothing less. If it helps, you can think of it this way: You won’t beat the market, but you will do much better than most people. Unfortunately, you may have to wait a few years to get your “I-made-more-money-than-you-in-the-stock-market” moment, or at least wait until the next market correction. 3. There are ways to get outsized returns. This plan ignores them completely. Equity markets provide a wide selection of choices. Between the NYSE and NASDAQ alone, there are more than seventeen hundred issues to choose from. These markets include all the largest public companies, including such monsters as Apple (NASDAQ: AAPL ) and Google (NASDAQ: GOOG ) (NASDAQ: GOOGL ). In the broader universe of financial contracts to choose from, there are all kinds of financial papers just waiting to be traded for outsized gains. I describe some possible ways of dealing with this disadvantage further on in the article, by allocating part of your portfolio to other investments. 4. It seems so extreme. Just one security? It’s actually extensive diversification over the best asset class. Probably a lot more diversified than most portfolios. The single security represents 500 companies (actually 502 at last count ). Diversification is a whole topic onto itself. The addition of treasury bonds to the plan, as well as incorporating other investment strategies is discussed below. Incorporating Treasury Bonds Into The Portfolio Incorporating treasury bonds can be done to address either of the following two goals: (1) Additional diversification into another asset class. (2) Allowing more activity while still maintaining good automatic decision making. Over the short term, bond prices tend to move in the opposite direction of stock prices. If stocks drop (or rise) significantly in price in a short period, the owner of an all-stock portfolio may feel that some kind of response is required of them. As stated before, I do not believe this to be the case. However, if such an itch needs to be scratched, a good option for doing so is rebalancing the portfolio between equity and bonds. If either of the above issues is a concern, incorporate the following two steps into the plan: Hold no more than 25% of the portfolio in Treasury Inflation Protected Securities (TIPS). Rebalance the portfolio if it skews more than 10% off the 25/75 division. TIPS are a fantastic security. They are US treasury bonds where both the principle and coupon are pegged to inflation. I have a strong preference for TIPS bought either at auction, or below (inflation adjusted) par value on the secondary market. If so bought and held to maturity, they will ensure a profit (although possibly a small one) and act as perhaps the best inflation hedge attainable. Unfortunately, at the time of writing, government-backed bonds are very expensive and do not offer much. TIPS, even if bought at auction, are sold with very low coupons. For this reason only, they were not included in the most basic plan. However, incorporating TIPS bought at, or below, par value for a 25% stake of the portfolio should still offer many advantages as discussed. Also, since this plan takes a very long-term approach, there is no reason that bond markets will not return to lower prices in the future. In this case, incorporating TIPS into the portfolio will be very advantageous. I do not recommend buying any other type of government bond, and I recommend against buying any kind of bond ETF. The reasons for this are perhaps the subject of another article. Going Past Market Returns Add the following steps if you want to incorporate or experiment with more investing strategies: Allocate 10% of the portfolio for doing whatever you want. At the end of the year, examine your results, and reallocate the portfolio based on your conclusions. If you want to make huge gains in a short period of time, go for it. Keep most of your money in SPY. Use only a small amount of your portfolio for other adventures. Over time, once a year, re-evaluate the performance of your “adventurous” portion of the portfolio and compare it to the results achieved by the remainder of the portfolio following this basic plan. If you are happy with your results, divert more money into direct active management. Perhaps adding 10% or 20% more. The important point is to do so incrementally, and at predetermined times. If you are able to make great investment decisions, and have the time and will to do so, the basic plan will be of no further use to you. Exiting it gradually will allow a learning period, and hopefully prevent jumping ahead too soon. I do not know of any discipline worth pursuing that does not require years to develop an ability for, and yet more years to master. Investing is no exception to this. The simple plan presented here allows to enjoy gains while still learning. It also acts as a fall back plan if better results cannot be achieved. Self evaluation is very personal and not at all simple. However, doing so is extremely beneficial and it too can be developed over time. The Extended Plan Summarized Allocate 10% of the portfolio for doing whatever you want. Of the remaining portion, h old 7 5% in SPY and 25% in TIPS Use additional received funds from savings, dividends, or interest to buy more SPY and TIPS using only a calendar to time purchases every 6 or 12 months. Rebalance the portfolio if it skews more than 10% off the 25/75 division. Reevaluate on a predetermined 12-month basis. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

The Global X MSCI Pakistan ETF: High Growth, Low Valuation And Decreasing Terrorism

Summary Pakistan’s stock market has risen substantially since 2012, yet valuation is still extremely low. Pakistan’s stock exchange has had substantial performance with a YTD return of 8.87%, and a 1 year return 21.18%. Terrorism has been decreasing substantially in Pakistan, according to a report released by the Department of State. Inflation has recently improved from the high levels consistently experienced between 2010 and 2014. Certain industries have displayed substantial growth, such as the cement industry, which grew by 57% this year. The Global X MSCI Pakistan ETF (NYSEARCA: PAK ) is an excellent value pick, and a closer examination of Pakistan’s economy, stock market, and political risk all verify that soon to emerging Pakistan is an excellent investment climate. The fund’s P/E ratio is currently 9.12, which is low for Pakistan, and is also lower when compared to other ETFs in frontier and emerging markets. The ETF was just created this year, and its price has consistently been between 14.00-16.94. PAK data by YCharts The Karachi Stock Exchange Pakistan’s stock exchange has had substantial performance with a YTD return of 8.87%, and a 1 year return 21.18%. Such a high index gain could be met with further growth, by strategically investing in undervalued companies. The Global X MSCI Pakistan ETF is an excellent way to potentially outperform the index, while the true value of value investing in individual companies is unfortunately unavailable to US investors. (click to enlarge) Source: Trading Economics The fund invests in some of the largest market cap companies from the KSE 100 index. Liquidity of the Karachi stock exchange is very high, with the top 20 most liquid stocks trading between 2 million to 12 million shares daily. The average P/E for the 20 most undervalued companies from the KSE 100 index is 6.6. Substantial higher valuation can be found for other companies from the KSE 100, verifying that the fund can overall be considered cheap. Pakistan’s Annual GDP Growth (click to enlarge) Source: Trading Economics Pakistan’s annual GDP growth is expected to increase to 4.96% by the 2nd quarter of 2016 . The correlation between GDP growth and the gain of Pakistan’s stock market is clear, by examining the rise that began in 2012, and the lower levels of growth experienced in 2010. Consumer Spending/Inflation (click to enlarge) Source: Trading Economics Consumer spending growth has been substantial in Pakistan, further attributing to the country”s economic growth. (click to enlarge) Source: Trading Economics Inflation has currently become drastically lower, and is projected to remain near 2% during the next 12 months. This represents substantial improvement from the drastically higher levels of inflation between 2010 and 2014. From Frontier to Emerging Pakistan is on track to soon be an emerging market, and high levels of economic growth can be seen, with specific industry outliers that are displaying substantial growth. Charlie Robertson, London-based chief economist at Renaissance Capital Ltd., said the following regarding the untapped potential of Pakistan: “It is the best, undiscovered investment opportunity in emerging or frontier markets. What’s changed is the delivery of reforms-privatization, an improved fiscal picture and good relations with the IMF.” The IMF has said that Pakistan is making excellent progress in meeting targets for economic growth. Pakistan’s cement industry in particular has displayed substantial growth, with 57% growth in the past year. D.G Khan Cement gained 62% this year, Maple Leaf Cement Factory Ltd. gained an impressive 161% this year, and Fauji Cement Co. gained 81%. The nation’s construction industry is also a bright spot, as it grew by 11.3%, nearly double the 5.7% target. Decreasing Terrorism Apart from the fact that Pakistan’s stock market has done nothing but soar since 2012, amidst issues with terrorism, investors can feel further confidence regarding the trends of reduction of terrorism in Pakistan. According to a report released by the US Department of State , Pakistan was among the top of a list of 95 countries in the world where terror attacks decreased. The overall increase of terrorist attacks and deaths in these 95 countries was 35% and 81% respectively, edifying that Pakistan is an outlier in terms of decreasing terrorism. With low valuation and high growth, investors can feel further confident in Pakistan, as terrorism is decreasing substantially. Conclusion Now is certainly a strategic time to invest in Pakistan, as valuation is current low, and the country is experiencing substantial growth. Inflation has drastically improved from the high levels from 2010 to 2014, and terrorism has very recently been declining faster than other countries. The Global X MSCI Pakistan ETF is an excellent way to profit from Pakistan’s growth, with the superior model of directly invest in equity in Pakistan not being available to US investors. The newly launched fund’s price has remained relatively consistent, and valuation is still incredibly low. Now would buy an excellent time to buy and hold long term, waiting for an increase in price to come as investors realize Pakistan’s potential. Until then, Pakistan’s status is certainly being relegated, and the early movers are sure to receive substantial returns. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Investing Alongside Buffett, Klarman, And Other Top Investors While Limiting Your Risk

Summary An investor can precisely limit his risk while maximizing his expected return by creating a hedged portfolio. When creating a hedged portfolio, you can start from scratch or start with a list of top picks. We lay out the second method here and provide an example. The example hedged portfolio was designed for investors willing to risk a maximum drawdown of 20%. Investors with lower risk tolerances can use a similar process, though their expected returns would likely be lower. Investing In An Uncertain Market Investors could be forgiven for wanting to limit their risk given the uncertainty about the current economic environment. Let’s recap the latest bit of news adding to the uncertainty, and then look at a way we can invest alongside some of the world’s best investors while limiting our risk. Reactions to the August jobs report released on Friday varied. The White House highlighted the positive: Our economy has now added 8.0 million jobs over the past three years, a pace that has not been exceeded since 2000. And while the economy added jobs at a somewhat slower pace in August than in recent months, the unemployment rate fell to 5.1 percent-its lowest level since April 2008-and the labor force participation rate remained stable. And the Wall Street Journal pointed out the dark cloud inside that silver lining: The labor-force participation rate stayed the same last month at 62.6%.The participation rate-the share of the population either working or actively looking for work-has been dropping for several years and is near levels last consistently recorded in the late 1970s, a time when women were entering the workforce in larger numbers. The latest reading is a result of the labor force shrinking by 41,000 last month, despite other signs of an improving jobs market. As the New York Times noted , the jobs report gave ammunition to both sides of the Fed rate debate, but, as Seeking Alpha news editor Carl Surran summarized it, the market’s verdict seemed to be negative, with the major market indexes down on Friday and all ten sectors in the red. Dealing With Uncertainty After all the analysis, no one knows what direction the market will take from here. One way to deal with uncertainty about market direction is to invest in a handful of securities you think will do well, and hedge against the possibility that you end up being wrong. That approach is systematized in the hedged portfolio method, which we detailed in a previous post (“Backtesting The Hedged Portfolio Method”). One advantage of the hedged portfolio method is that it can accommodate a broad range of risk tolerances. If you can tolerate a drawdown of more than 20%, our research (summarized in the previous post we mentioned above) suggests that with our security selection method you can achieve returns as good or better than the market over time with less risk. Maybe You Can Do Better It’s possible you can get even better returns with the hedged portfolio method by selecting your own securities. And if you’re going to do that, a good starting place for ideas is to look at what some of the best investors in the world have been buying. Seeking Alpha contributor and hedge fund manager Chris DeMuth, Jr. did just that in a recent article (“Best Q2 Picks From Top Investors”). In that article, DeMuth examined reported buys from leading investors and highlighted a number of them. These were the stocks, along with the investors who bought them: SunEdison Semiconductor (NASDAQ: SEMI ) – Seth Klarman. Precision Castparts (NYSE: PCP ) – Warren Buffett SunEdison (NYSE: SUNE ) – David Einhorn Perrigo (NYSE: PRGO ) – Stephen Mandel (former analyst for Julian Robertson) Williams (NYSE: WMB ) – Dan Loeb Danaher (NYSE: DHR ) – John Griffen (another former protege of Julian Robertson) Time Warner Cable (NYSE: TWC ) – John Paulson Baker Hughes (NYSE: BHI )- Jeff Ubben Shire (NASDAQ: SHPG ) – Leon Cooperman Office Depot (NASDAQ: ODP ) – Richard Perry Humana (NYSE: HUM ) – Larry Robbins Cigna (NYSE: CI ) – Andreas Halvorsen Altera (NASDAQ: ALTR ) – Andrew Spokes Icahn Enterprises (NASDAQ: IEP ) – Carl Icahn Brookdale Senior Living (NYSE: BKD ) – Barry Rosenstein T-Mobile (NYSE: TMUS ) – Phillippe Lafont DeMuth’s article is worth a read for some color on these stocks and investors (particularly, the less well-known investors). But we’ll start with the assumption that most of these are solid stocks, and we’ll use them as a starting point to construct a hedged portfolio for an investor who is unwilling to risk a drawdown of more than 20%, and has $1 million he wants to invest. First, though, address the issue of risk tolerance, and how it affects potential return. Risk Tolerance and Potential Return All else equal, with a hedged portfolio, the greater an investor’s risk tolerance — the greater the maximum drawdown he is willing to risk (his “threshold”, in our terminology) – the higher his potential return will be. So, we should expect that an investor who is willing to risk a 20% decline will have a chance at higher returns than one who is only willing to risk, say, a 10% drawdown. Constructing A Hedged Portfolio In the previous article mentioned above, we discussed a process investors could use to construct a hedged portfolio designed to maximize potential return while limiting risk. We’ll recap that process here briefly, and then explain how you can implement it yourself. Finally, we’ll present an example of a hedged portfolio that was constructed this way with an automated tool. The process, in broad strokes, is this: Find securities with high potential returns (we define potential return as a high-end, bullish estimate of how the security will perform). Find securities that are relatively inexpensive to hedge. Buy a handful of securities that score well on the first two criteria; in other words, buy a handful of securities with high potential returns net of their hedging costs (or, ones with high net potential returns). Hedge them. The potential benefits of this approach are twofold: If you are successful at the first step (finding securities with high potential returns), and you hold a concentrated portfolio of them, your portfolios should generate decent returns over time. If you are hedged, and your return estimates are completely wrong, on occasion — or the market moves against you — your downside will be strictly limited. How to Implement This Approach Finding promising stocks In this case, we’re going to start with the list of Q2 best picks curated by Chris DeMuth. To quantify potential returns for these stocks, you can, for example, use analysts’ price targets for them and then convert these to percentage returns from current prices. In general, though, you’ll need to use the same time frame for each of your potential return calculations to facilitate comparisons of potential returns, hedging costs, and net potential returns. Our method starts with calculations of six-month potential returns. Finding inexpensive ways to hedge these securities First, you’ll need to determine whether each of these top holdings are hedgeable. Then, whatever hedging method you use, for this example, you’d want to make sure that each security is hedged against a greater-than-20% decline over the time frame covered by your potential return calculations (our method attempts to find optimal static hedges using collars as well as protective puts going out approximately six months). And you’ll need to calculate your cost of hedging as a percentage of position value. Selecting the securities with highest net potential returns In order to determine which securities these are, out of the list above, you may need to first adjust your potential return calculations by the time frame of your hedges. For example, although our method initially calculates six-month potential returns and aims to find hedges with six months to expiration, in some cases the closest hedge expiration may be five months out. In those cases, we will adjust our potential return calculation down accordingly, because we expect an investor will exit the position shortly before the hedge expires (in general, our method and calculations are based on the assumption that an investor will hold his shares for six months, until shortly before their hedges expire or until they are called away, whichever comes first). Next, you’ll need to subtract the hedging costs you calculated in the previous step from the potential returns you calculated for each position, and exclude any security that has a negative potential return net of hedging costs. Fine-tuning portfolio construction You’ll want to stick with round lots (numbers of shares divisible by 100) to minimize hedging costs, so if you’re going to include a handful of securities from the sort in the previous step and you have a relatively small portfolio, you’ll need to take into account the share prices of the securities. Another fine-tuning step is to minimize cash that’s leftover after you make your initial allocation to round lots of securities and their respective hedges. Because each security is hedged, you won’t need a large cash position to reduce risk. And since returns on cash are so low now, by minimizing cash you can potentially boost returns. In this step, our method 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 leftover cash to one of the securities you selected in the previous step. Calculating Expected Returns While net potential returns are bullish estimates of how well securities will perform, net of their hedging costs, expected returns, in our terminology, are the more likely returns net of hedging costs. In a series of 25,412 backtests over an 11-year time period, we determined two things about our method of calculating potential returns: it generates alpha, and it overstates actual returns. The average actual return over the next six months in those 25,412 tests was 0.3x the average potential return calculated ahead of time. So, we use that empirically derived relationship to calculate our expected returns. An Automated Approach Here we’ll show an example of creating a hedged portfolio starting with Chris DeMuth’s best Q2 picks using the general process described above, facilitated by the automated hedged portfolio construction tool at Portfolio Armor . In the first step, we enter the ticker symbols in the “Tickers” field, the dollar amount of our investor’s portfolio (1000000), and in the third field, the maximum decline he’s willing to risk in percentage terms (20). In the second step, we are given the option of entering our own return estimates for each of these securities. One of these securities, PCP, appeared in a hedged portfolio in a previous article (“An Alternative To Cash For A Risk Averse Investor), and there, we used Portfolio Armor’s calculated potential return for it. In this case, for illustration purposes, we’ll enter a potential return for it based on the assumption that the Berkshire Hathaway deal closes at the announced price of $235 per share. For the other securities, we’ll let Portfolio Armor supply its own potential returns. A couple minutes after clicking the “Create” button, we were presented with the hedged portfolio below. The data here is as of Friday’s close. Why These Particular Securities? The site included all of the entered securities for which it calculated a positive potential return, net of hedging costs. Interestingly, one of the stocks it rejected, Icahn Enterprises , is one Chris DeMuth mentioned as a short position earlier this year, as he noted in his Best Q2 Picks article. In its fine-tuning step, Portfolio Armor added Google (NASDAQ: GOOG ) as a cash substitute. Let’s turn our attention now to the portfolio level summary for a moment. 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 19.67%. Negative Hedging Cost Note that, in this case, the total hedging cost for the portfolio was negative, -1.03%, meaning the investor would receive more income in total from selling the call legs of the collars on his positions than he spent buying the puts. Best-Case Scenario At the portfolio level, the net potential return is 13.44% over the next six months. 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 4.63% represents a conservative estimate, based on the historical relationship between our calculated potential returns and backtested actual returns. However, since these securities are picks of some of the world’s best investors, it’s possible Portfolio Armor is underestimating their returns over the next six months. By way of comparison, if you created a hedged portfolio on Friday using the same dollar amount ($1,000,000) and decline threshold (20%), but without entering any ticker symbols (i.e., you let Portfolio Armor pick the securities), the expected return for that hedged portfolio would have been 7.97%. That hedged portfolio would have only had one primary security in common with this one; as you can probably guess from the potential returns shown in the hedged portfolio above, that security was Advance Auto Parts. Each Security Is Hedged Note that each of the above securities is hedged. Google, the cash substitute, is hedged with an optimal collar with its cap set at 1%; Advance Auto Parts and Precision Castparts are hedged with optimal puts; and the remaining securities are hedged with optimal collars with their caps set at each underlying security’s potential return. Here is a closer look at the hedge for Advance Auto Parts: The cap field above is blank, because this isn’t a collar. Portfolio Armor used optimal puts in this case instead of an optimal collar because the position had a higher net potential return this way (it calculated the net potential returns both ways for each of the primary positions in the portfolio). As you can see at the bottom of the image above, the cost of this hedge was $2,500, or 2.90% of position value.[i] Note that, although this hedge had a positive hedging cost, the hedging cost for the portfolio as a whole was negative. Possibly More Protection Than Promised In some cases, hedges such as the ones in the portfolio above can provide more protection than promised. For an example of that, see this recent instablog post on hedging Tesla (NASDAQ: TSLA ). Hedged Portfolios For Smaller Investors The hedged portfolio shown above was designed for someone with $1 million to invest, but the same process, with a couple of minor adjustments, can be used for those with smaller amounts to invest. We walked through creating a hedged portfolio for someone with $30,000 to invest in an article last month (“Keeping a Small Nest Egg from Cracking”). [i] To be conservative, the cost of the put protection was calculated using the ask price of the puts. In practice, an investor can often buy puts for less than the ask price (i.e., at some price between the bid and ask). So, in practice, an investor would likely have paid less than $2,880 for this hedge. A similarly conservative approach was used for calculating the costs of all of the hedges in this portfolio (with the cost of puts calculated at the ask and the income from calls calculated at the bid). Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.