- Don’t let the Bear send you into a panic frenzy
- Using a typical hedge strategy with options and futures
- Taking advantage of lower prices to rebalance your portfolio
Bear markets when they happen are never a pleasant event for any investor. Long only investors especially tend to be the worst hit. If you are wealthy enough to invest in Hedge Funds you may be damaged less, if you chose the right managers and the right strategies [5]. Despite the pain felt, market corrections if managed correctly, should be seen as an opportunity.
Many investors run for the door when markets become volatile, meaning the turn south sharply. Yet that may not be the best choice. There are certainly more alternatives to simply cutting your positons in stocks. If you have built up a portfolio of stocks you feel will perform brilliantly and have an exciting future ahead you may not be willing to take losses simply because the market is making a correction.
Another reason not to sell is that you are most likely to sell when the market is bottoming out. Most investors will sit with their stock positions and ride the volatility rollercoaster. The thinking, which is also true, is that at some point the economy will become expansive again and the market will correct itself. But then that turn around takes longer than expected and when the pain is too much the positions are liquidated. Unfortunately that often coincides with market lows or near market lows and a lack of confidence to get back into the market.
Typical Hedges
Many equity hedge fund strategies make use of futures in broad indices in an attempt to eliminate the systematic risk of holding positions in shares. However the use of futures can be very useful even if you’re not a stock trader [6] but more of a long term investor. It’s important to understand cyclicality and that there will be periods when the broad stock market will decline and investments may lose money, on paper.
So having a clear market vision can greatly help you offset market Bears when they happen. The general stock market seems ripe for an extended correction over the next months. So selling futures or buying put options may seem an obvious and effective hedge. These strategies however, if not well timed, can prove to be expensive to maintain especially when volatility is high.
Portfolio balancing
There’s another way to ride lower prices without being exposed to more risk. Having positions in futures or options even if they are offsetting to your stock positions can still create negative cash flows. Portfolio rebalancing [7] involves bringing your portfolio allocations back in line with your initial ratios for each asset or in line with another specified rule. There are two ways to implement this strategy; Constant Mix and Constant Proportion.
Constant Mix
Let’s say you have a two asset portfolio of stocks and bonds to keep it simple and that the bonds are risk free. You have total assets of $200, and your initial allocation is a 50 50 split between the two assets. The initial investment amounts are $100 in stocks and $100 in bonds. If the Stock market makes a 10% correction, your portfolio now comprises $90 in stocks and $100 in bonds. Clearly your initial allocation has broken down and your portfolio in now over-weighted in bonds.
To bring your portfolio back to the original weights you will need to sell some of your bonds and buy more stock. Ok, that sounds like contrary to common sense if the market is going to decline further. True, but what if the market doesn’t decline? And in the meantime this strategy won’t be costing you money or extra risk as would options or futures.
Source Dynamic Strategies for Asset Allocation, Perold & Sharpe
You would now have total assets of $190, this means that your original weighting of 50/50 would result in a portfolio with $95 in both stock and bonds. You would then need to sell $5 of bonds and buy $5 of stock. This strategy will get the most benefit when markets are volatile. As you will be buying stocks on dips to then sell them back again on spikes. This strategy will not perform as well as a buy and hold strategy if the market moves in one direction only with no corrections. Integrity
Constant Proportion Strategy
In this case the rebalancing involves selling stocks when the market goes down and buying stocks when the market goes up. Continuing this time with a $100 portfolio, Constant Proportion Portfolio Insurance (CPPI) involves establishing a floor for the amount of Bonds to be held in the portfolio. This acts as a cushion, in the sense that if the value of stocks were to fall to zero the portfolio would consist entirely of Bonds. The strategy is given by the following formula:
You would choose the level of the floor and the multiple according to your appetite for risk. Once total assets equals the amount of the floor you would not hold any stocks at all. However as the value of stocks rises the multiplier would mean you hold more and more in stocks.
Let’s say your initial floor is $75 with a multiplier of 2. Your initial cushion would then be $100-$75 or $25 and your stock exposure should equal 2 X $25. You would begin with a 50/50 allocation to bonds and stocks. If stocks where to go down by 10% you now hold $45 in stocks and total assets would equal $95. The above formula would give you a stock position of $40 ($95-$75 times 2). You would then sell $5 of stocks and buy $5 of bonds.
This strategy can protect the downside as your losses are limited by the floor. It also works best when the market moves in one direction without too many large corrections.
Source Dynamic Strategies for Asset Allocation, Perold & Sharpe
That explains the easy part; there are probably more difficult aspects of implementing either of these two strategies. What are the metrics for choosing how often to rebalance? Rebalancing too often will create greater costs and may diminish your returns. Whereas not rebalancing often enough may cause you to lose the benefits of rebalancing. How far should the market move before it triggers the need to rebalance? And finally which one is the most appropriate going forward considering the market conditions we are likely to face? Most likely the CPPI would have outperformed both buy & hold and constant mix over the past 6 years. But that might be changing over the next year as we begin to tread more volatile territory. The decision also goes back to your investment horizon and how comfortable you may feel for example about buying more stock when the market is going down.