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By Jay Pestrichelli

Hedging strategies can help financial advisers limit volatility in client portfolios, while also providing much-needed income for clients before or during retirement.

To invest is to take on risk. There is no other way. You cannot completely avoid, replace, or eradicate the risk present in any investment portfolio strategy. You can only manage it. 

Some financial advisers use diversification to manage risk, which works fine, until it doesn’t, as seen during the steep market declines in March 2020 and September 2008.

Others might use the traditional 60/40 portfolio of stocks and bonds. Or the traditional rule of thumb of subtracting your client’s age from 100 to determine the percentage of stocks a client should be invested in given their proximity to retirement.

The challenge with having as much as 40% of a client’s portfolio in bonds is that bond holders may be taking on significant interest rate risk given inflation and the expected Federal Reserve tightening and rate hikes this year.

So, what kind of investment or strategy can provide that safety without compromising on returns?

That’s where hedging strategies can come into play. But what do I even mean by hedging?

What Is Hedging?

Hedging involves using options, among other instruments, to limit an investment portfolio’s downside. It can essentially provide a floor under some of the portfolio’s investments.

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This provides a level of certainty on how much the portfolio can decline regardless of how deep a broader stock market selloff becomes. Hedging is protection against the unknowable. Clearly you don’t know – and I can’t tell you - precisely what the market is going to do tomorrow, next week or by the end of year.

What Does Hedging Accomplish?

Hedging reduces the need to try and time the market perfectly. During times of market declines, your clients may call you asking to remove all of their money from the market for fear of additional losses ahead. If clients sell during a market downturn, they are not only locking in losses, but they are also likely going to miss out on the market’s eventual rebound.

Hedging strategies may increase the chances of your clients staying invested in the market. Hedging strategies can be beneficial to those entering their retirement years. An investor in their 60s doesn’t necessarily have enough time to wait for the stock market to rebound after a bear market. But they still need the growth (whether through dividends or capital appreciation) that the stock market provides. This is especially true in our low interest rate environment.

At ZEGA Financial, we believe our hedging strategy, which we call “buy and hedge,” (instead of the traditional adage of “buy and hold”) is a replacement for the traditional 60/40 stock and bond allocation.

Financial advisers know their clients better than anyone, but for those in or approaching retirement with growth needs, an allocation to a hedging strategy can replace all or a significant portion of their moderate portfolio.

Most advisers using diversification hoping that it will offset losses can look to hedged equity as an alternative to traditional bond allocations.

A Good Defensive Plan

As with any well-coached football team, a good defensive plan creates scoring opportunities for the offense.

That’s how hedging allows for the best of both worlds: limiting the downside while positioning client portfolios for the healthy rate of return they expect from their portfolio’s core holdings.

In the end, investors want to reach their goals and sleep a little better at night. Hedging can be just that solution.

About the author: Jay Pestrichelli is the CEO of ZEGA Financial, an investment firm based in West Palm Beach, Fla. He is also the portfolio manager of the ZEGA Buy & Hedge Exchange-Traded Fund ZHDG. Pestrichelli is author of the 2011 book Buy and Hedge: The Five Iron Rules for Investing Over the Long Term.