Why? Monumental losses are extremely difficult to make up. If you have a big loss, in the most basic absolute sense you are much worse off than you were prior to the loss (obviously); however, it is possible that relatively (e.g. vs. the market) your return wasn’t terrible (e.g. S&P 500 is down 50% and your equity portfolio is down 45%).
On the flip side, missing gains may leave you frustrated, as relatively you may have underperformed; however, in absolute terms you are probably no worse off than you were before.
Here is a simple example: In a fantastic year let’s say equities are up 50%. In such a year a well-hedged investor may be up 10% to 25%. Now obviously getting the whole 50% would have been the desired outcome, but the value of the portfolio is still higher than before without compromising the long-run goals and objectives.
On the other hand, if equities have a miserable year and decline 40%, a non-hedged investor will be down the full 40%. In contrast, a well-hedged investor may only be down 5% to 15%. The non-hedged investor now has a significant uphill battle just to get back to even – a gain of roughly 67%. A loss of this size can seriously hamper the investor’s ability to reach his or her long-run goals and objectives.
As I mentioned in the title, such a concept is totally subjective on my part. I just look at losing big on the downside and don’t see how it’s worth it. As such, for our clients we will build in a variety of hedges to try and mitigate extreme downside risk. The strategies can be as simple as selling at various targets on the S&P 500 Index or more complicated like using derivatives.
