5 ways to effectively hedge your investments
Portfolio hedging is a form of insurance to protect your portfolio from a deep draw-down in the event of a steep market fall. With equities hitting all time highs in this bullish market and demanding sky high valuations there is a sense of caution that we are veering into a bubble territory.
When to Hedge Portfolio
Hedge your portfolio if you meet the below criteria
When you have a reasonable belief that market is going to correct steeply over a specific period of time either due to an event risk or high valuations or some other reason. The time period for your belief to play out can be 2 weeks, 1 month, 2months, 6 months or 3 years.
If the portfolio worth is greater than 3 lakhs.
If there are reasons not to exit & re-enter the portfolio either for tax purpose, dividends or fear of timing the re-entry (or fear of missing out).
When you are willing to pay the risk amount of at least 1% of your portfolio value to hedge.
If you have a portfolio that is not mid-cap/small-cap stocks heavy. I will explain the reason later in the article.
And finally, you should have a good understanding of options.
If you have met the above criteria, then you can be certain that your portfolio needs hedging. Otherwise, explore other possibilities which I will list later in this article to control the risk to your portfolio .
How to Hedge your Portfolio
The most simple form of hedging a portfolio is to buy an option to protect from the downside risk. But it is important to understand what kind of options and how many options need to be bought for hedging.
An ideal hedging option has two components – efficiency and cost-effectiveness. A hedge is efficient when it provides a one to one protection. A 10% draw-down in your portfolio should be compensated by an equivalent gain in your put option thus offsetting the draw-down. A hedge is cost-effective if it provides downside protection to your portfolio at reasonable cost without eating into you returns.
Here are 5 ways you can hedge your portfolio:
1) Minimize investment weightage
• Overall weight of small-caps in portfolio should be less than 25%
• Invest 75% of funds in large-caps
• This can protect against market volatility
2) Restructure your portfolio
• But in small-caps too, there may be well-known, tried-and-tested options
• During market uncertainty, select these stocks instead of unknown risky stocks
• In the small-cap segment, any stock can fail
• That’s why invest in at least 10 companies to hedge against loss
• Invest equally in all these stocks
• This way, you can ensure that not all stocks perform poorly
4) Have a long-term view
• Invest in small-mid cap companies with a long term approach
• Identify financial goals you want to achieve in 5-10+ years and invest towards them
• Avoid debt-burdened companies
• Invest fixed portion of total corpus for mid-caps
• Remain invested till the stock is not growing more than 4 times
5) Invest where you are competent
• There are a lot of industries in the small-cap segment
• Steel, pharma, mining or agriculture, for example
• Do you have in-depth knowledge about any industry?
• Invest in small-cap stocks of that industry
• This can reduce your risk and increase your investment competence