The Best Hedge There Is

My friend Tracy Alloway has the definitive article about what went on with the volatility exchange traded products that blew up this week and probably triggered the historic bout of volatility we’re undergoing right now. The fact that these are Frankenstein products, built by maniacs, for use by maniacs, should be stated at the outset.

Here’s a sample quote from the story so you can understand what we’re dealing with:

“If you’re going to play the short-vol game, basically the goal is to just stay alive and avoid any circumstance where things can go up in smoke in minutes.”

Six years ago I sat on an ETF panel discussion for the New York Society of Security Analysts (NYSSA) and one of the creators of these “funds” tried to get cute with me when I explained this in front of the crowd. He was feeling like a big shot because he had just sold his company to a larger fund company and it was apparent in his haughty demeanor on stage. My point was that, yes, traders may find uses for this type of instrument (traders I know would also bet on two fruit flies racing each other to land on a bowl of peaches), but that investors don’t need this stuff and it may even prove to be toxic to the overall markets in certain scenarios.

Welp…

Here’s the deal: There’s a smart way and a stupid way to hedge against risk in a portfolio.

Smart people start out with a simple question – “How much risk do I actually need to take?” The answer to this question can be found in working with a financial planner, calculating what it might cost for your family to achieve all of its goals – both required goals and the stretch-y kind – and then working backwards to arrive at a somewhat optimal portfolio. That way, you are only taking the necessary risks to do what you want to do and fund the future liabilities that are important to you.

A stupid person starts off by assembling a portfolio based on what they think is going to happen and then scrambling for hedges and exotic products when their gut tells them there might be more or less risk in a given period – with no context about why they’re investing, when they’ll be using the money, etc. “Look at me, I’m hedging!” 

And I won’t even get into the whole discussion about how volatility and risk are two terms that should not be used interchangeably for most investors, because the real risk is not a fluctuating account value. The real risk is arriving at some later point in time and discovering that you haven’t saved enough or taken enough risk to lead the lifestyle you’d hoped for (aka running out of money at a time in life where you can’t replace it with new income).

The best hedge there is? Not taking risks you don’t need to take.

We work with clients to figure out the answer to this question and allocate accordingly. It’s better to have the right amount of exposure to an asset class than to have too much exposure and spend your time looking for expensive ways to offset it.

You would think this would be obvious, but alas…it’s not. No one has a vested interest in teaching this to people. Brokerage firms make more money putting flashing lights on the user interface dashboard, conferring an illusion of control, as though you’re sitting in some sort of cockpit with switches to flip and instruments to make moves with.

As for the people blown up by shorting volatility, or going long volatility in the wrong way via a flawed product? Play stupid games, win stupid prizes.

Vol trading is for professional traders. Everyone else should be taking the right amount of risk so that vol isn’t a potentially destructive issue.

If you want to get off the merry-go-round, talk to us here. Certified Financial Planners are standing by.