Many readers have inquired about how much of their portfolio should actually be hedged to reach 100% portfolio protection. This is not an easy question to answer as each portfolio is unique. The particular portfolio may include stocks, bonds, ETFs, mutual funds, options, REITs and MLPs. Some of these investments (such as defensive stocks) are inherently partial hedges and need not be fully considered in hedging a portfolio.

So, before determining how much to hedge, we must first determine the risk level of the portfolio. The most common determinate for risk level is BETA. That is, how does a particular investment move in relation to the S&P 500? A BETA of ONE means that the investment is perfectly correlated to the S&P 500. Theoretically it will mimic the movement of the S&P. A BETA of TWO means that the investment will move twice as much as the S&P and a BETA of .50, half as much.

Many of my hedging strategies use the iShares S&P 500 ETF (NYSEARCA:SPY) as a surrogate for a portfolio. So, if one could represent their portfolio risk as BETA they could easily determine the amount to hedge using SPY.

For instance, let’s say a particular stock portfolio consisted of some defensive stocks and the BETA of the overall portfolio was .75. The investor need only hedge 75% of their stock portfolio using SPY as a surrogate to reach 100% portfolio protection. The inherently defensive positions provide the other 25%.

On the other hand, let’s say the portfolio was aggressive and had a BETA of 1.50. In this case, they would need to hedge 150% of the value of the portfolio with SPY. If the investments that were increasing the BETA were, say, technology companies, they might prefer to hedge by mixing in some QQQ hedges instead of all SPY hedges.

So, this all begs the question of how does one determine a portfolio BETA? BETA for a particular stock is calculated using a very complex formula. Portfolio BETA is orders of magnitude more complex. I have found some web-sites that will compute an approximate BETA for a portfolio input. They can be helpful but I haven’t found any that can factor in options.

In any event, there is an easy and effective way to determine your own personal BETA. It uses OBSERVATION instead of calculus.

Just compare your portfolio movements to the S&P on days the S&P moves down. Let’s say the S&P moves down 1% on a given day. Well, if your portfolio moved down .65%, then your “preliminary” BETA is .65. You need to take several readings on different days, as certain sectors can drive the S&P in different ways than your own portfolio. If you see a steady correlation, you’re home free. If it varies widely from day to day, then you need to examine the reasons. One common reason would be a portfolio that is not well diversified or is “top-heavy” with a particular stock or sector. If so, you may want to look into hedging that particular position separately.

If the BETA is steady at .65 then a 65% hedge is sufficient.

Looking at your portfolio vs. S&P on down days doesn’t tell the whole story. You should also look at the correlation on up days. Let’s say you discover that your portfolio is 65% correlated to S&P on down days and only 50% correlated on up days. You never want to have more exposure on a down move than you have reward on an up move. You should look closely at your portfolio as some part, or parts, aren’t working harmoniously. You may find you have a particular stock or ETF that is "over-reacting" to bad news and "under-reacting" to good news. You may want to make the appropriate adjustments to improve your portfolio efficiency.

On the other hand, if you are 65% correlated on down days and 75% correlated on up days, BRAVO.

Using this method of BETA determination doesn’t take a lot of time or brain power and it can give you a pretty good idea of the risk level and efficiency of your portfolio.

It would be a good idea to continue to monitor your portfolio in this fashion as an ongoing project. By computing the up and down BETAs you can get an idea of the relevancy of your portfolio to the broader market and an indication if change is in order.

Also, monitoring AFTER any hedge is in place is important. Any hedge will initially trade some upside for downside protection. If the particular hedge takes more from the upside than it gains on the downside, you may want to make some adjustment. For example, lets’ say you were 65% correlated up or down. You put a hedge in place and find you are 20% correlated down and 10% correlated up. The downside protection is fine, but it is taking too much from the upside. The adjustment might be as simple as selling your weekly puts further ITM or lowering the strike on a protective put.

For those that like spreadsheets and graphs, the data could be very helpful when entered in any number of software programs. You can even make notes accounting for any unusual divergences.

Many investors like to compare their yearly returns to the S&P, and that’s fine. But, to me, it’s like reading a box score after the games played. I’m suggesting that it is more informative to see how you compare on up and down days as time progresses. This can tell you how likely you are to outperform going forward and give advance notice when change is in order.

Even if you never hedge any portion of your portfolio you can be alerted to inefficiencies in your portfolio makeup. The more you understand how things work, the better able you are to diagnose problems and fix them. Looking at your personal BETA and comparing your up/down BETA is possibly the most important step you can take.

**Disclosure: **I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I buy and sell SPY and QQQ options