No Matter the Market, Hedging Works
Balancing positions enhances return, reduces risk -- regardless of conditions.
"Buy and hold" has failed spectacularly over the past two years, and not for the first time. We examine market history and the observation that stocks don't behave uniformly with averages -- some will be significantly stronger, others significantly weaker. In that pluralism is a world of opportunity. Though the word "hedge" has fallen into disrepute, balancing simultaneous long and short positions can be an effective way to enhance return and reduce risk irrespective of market conditions.
There's a vast difference between "the average stock" and stock averages. Combining even middling outperforming long positions with equally middling underperforming short positions creates an enormous potential for diversified, stable, risk-protected returns exceeding indices. If the market sells off, for example, the long positions are impaired. But since they're index outperformers, the impairment is generally less than the fall in the market overall.
On the other hand, the short positions, as index underperformers, produce value at least to the extent as the deteriorating trend. Market neutrality may indeed be the most compelling alternative available for generating an enhanced, exposure-sheltered rate of return (ROR). And that sheltering aspect is especially noteworthy, as many investors who have been socked recently -- and are also facing retirement in the near term -- have also been tempted to take on greater risk in the hope they can make up for lost time and money.
The market collapses beginning in 2000 and 2007 are instructive for "buy and holders." Oft-ballyhooed expectations of 7%-10% annually have been realized only over lengthy periods of time. Market behavior during a particular individual's investing years may radically differ; ask any Baby Boomer ruined twice in the past decade. Despite the exhortation not to attempt timing, buy and hold inherently imports that element for those unwilling to hold stocks through market meltdowns. Panic late, and the upshot is either staggering portfolio loss or significant opportunity cost. And those who reallocate among stocks, bonds, and cash are -- timing.
Long-term market history (the following graphs the S&P 500 moving ten-year ROR since 1938) indicates the difficulties of both buy and hold and timing:
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The S&P 500 has spent a remarkable amount of time declining over the past 71 years. Bullish periods are almost equally counterbalanced by equivalently bearish periods. Buy-and-hold wealth accumulation over this era required owning stocks that performed as well as the index in bullish phases, and stocks that significantly outperformed the index in bearish phases. Despite smooth assurances from mutual-fund vendors and brokers, wealth-building through long-term and long-only stock ownership has been easier said than done -- except in bull markets. Success has required either exceptional stock-picking skills or the raw luck to begin at a bottom.
Did dividends make a crucial difference?
Not really. Yields were relatively high in the 1970s and early 1980s, but so was inflation. Since 1987, dividends have seldom ventured north of 3% annually despite record corporate earnings during the middle of this decade. Here's the yield experience over the past eight decades:
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Peak dividend periods tend to correspond with bear-market conditions; lower prices/higher yields. Growing corporate earnings tend to correspond with bull markets; higher prices/lower yields. The 2000-2003 bear market didn't result in meaningfully higher payouts in dollar terms. The lesson for "buy and holders" is to purchase dividend-rich stocks at market bottoms, as this combines yield attractiveness with maximum opportunity for accompanying price appreciation on the rebound. Yet this strategy is often dismissed as just another form of timing.
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