By Eric Fry Editor’s Note: Today’s article comes from Eric Fry, The Oxford Club’s Macro Strategist and a contributor to Energy & Resources Digest. If you haven’t already subscribed, click here – it’s free.
Recently, many subscribers have sent me emails that express concerns about the U.S. stock market’s lofty valuations. These subscribers want to know how to prepare for the “inevitable correction” and whether I would recommend any specific hedging techniques.
Unfortunately, there is never really a great answer to questions like these.
The U.S. market is certainly an expensive one. So buying stocks at their current lofty valuations is unlikely to be as rewarding during the next 10 years as it has been during the last 10 years. But trying to take proactive steps to guard against losses during a stock correction is never easy.
So what does an investor do?
The answer to that question is an intensely personal one. For example, an investor who has a large tolerance for risk and/or who is operating with a very long-term perspective may be comfortable holding a large percentage of their net worth in stocks.
Conversely, an investor with a low tolerance for risk and/or a short-term perspective may want to hold a relatively small percentage of their net worth in stocks.
In other words, a disciplined, personalized investment program is usually the best way to “hedge” your risks. If you remain within your comfort zone, you are more likely to give your investments the room they need to deliver large gains.
That said, almost every investor feels the urge to hedge against losses from time to time. So let’s take a look at four of the most common hedging tactics…
1) Raise cash by selling a portion of your stock holdings. For most investors, raising cash by reducing exposure to stocks is the only hedging technique that achieves any degree of success. The biggest risk it imposes is the risk of losing out on future gains.
But even this simple tactic is fraught with drawbacks. First, selling stock triggers a capital gains tax obligation in taxable accounts. That means you pay a tax of 15% to 20% on your profits for the privilege of avoiding potential losses.
The second drawback of selling stocks to avoid losses is that you never really know when you should repurchase the stocks you sold. It is easy to make the mistake of selling out of a winning stock and then never buying it back before it resumes moving much higher.
2) Buy protective put options. Put options provide another form of hedging. Typically, an investor would buy put options on an index like the S&P 500 to provide a hedge against the stocks they own.
Unfortunately, this technique tends to be very difficult and expensive to implement. Buying these options is a bit like buying a very expensive six-month fire insurance policy on your home. As long as your home burns down in six months, buying the insurance is a good idea.
But if the “house” doesn’t burn, you’ll be faced with the choice of buying another …read more
Source:: Investment You
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