Anatomy of a Down Market

Using Hedged Investing to Navigate the Worst of Times

As with all professional investors, we have an opinion about where the market is going, over the next few months and years, and even longer. Such forecasts do not contribute meaningfully to the investment decisions we make at Sungarden. Rather, our investment committee tries to focus on what is right in front of us. Instead of investing for a specific outcome, we gauge the possibilities, evaluate the tradeoff between reward and risk, and plan for anything.

As a regular course of business, we are hedged investors. Most of the time, there is some segment of the portfolio that exists to profit from a big loss in some segment of the stock market. We are rarely if ever all-in or all-out. That requires too much guessing and that is not what we get paid to do.

Recent market activity and near all-time highs in the stock market have caused us to take our ever-present concern for avoiding big losses, and placed it front and center in our internal strategy discussions. In order to provide a high-level view of how we look into the abyss of a period that potentially rhymes with 2002, 2008, etc., consider the following hypothetical example:


First 10% decline in market lose no more than 4%
Second 10% decline in market lose no more than 3% Third 10% decline in market lose no more than 2%

So, in a market decline of 30%, our maximum loss to consider ourselves to have slayed the bear is about 9%. That's 30% of the total decline. If we get to that point, the portfolio is largely insulated from much further damage, as we will be a largely defensive position.

We also know that if there is a big "V-shaped" move off the eventual bottom, we will lag behind for a while. But when "avoid the big loss" is your mantra, you trade off some upside to preserve capital relative to your peers, who are likely losing 20-30% or more in the same scenario. And while every investor is different, I feel comfortable in stating that the vast majority of investors I have met and helped would feel OK if they retained 91% of their capital in such a scenario.

None of this should be taken as an outright plan, and certainly not a guarantee. Every market is different, and we build our portfolios with a combination of stocks and inverse-ETFs, so there is some risk to our stock selection and other factors.

But here's the key: THE PLAN IS THOUGHT OUT IN ADVANCE. Oh, and here is another related thought…THERE IS A PLAN TO BEGIN WITH! This seems to be where many investors (and advisors) get lost. They set a plan, and get complacent. They justify holding successful investments longer than they should to defer capital gains taxes. Or they refuse to sell large losing positions because “if I give it enough time it will come back.” Famous last words.


(c) Sungarden Investment Research


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