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Since I began investing on my own over 40 years ago, every book I ever read and every professional I ever spoke to, gave me the same advice: "Hedge your positions to limit the downside risks". Basically, hedging an investment portfolio, such as our Team Alpha Portfolio, could have numerous strategies. Some are so complex that normal folks eyes glaze over just at the mere mention of hedging. I suppose that is the number one reason that most regular investors avoid hedging, including me.

Our portfolio now consists of Exxon Mobil (NYSE:XOM), Johnson & Johnson (NYSE:JNJ), AT&T (NYSE:T), General Electric (NYSE:GE), BlackRock Kelso Capital (NASDAQ:BKCC), KKR Financial (KFN), Procter & Gamble (NYSE:PG), Intel (NASDAQ:INTC), Realty Income (NYSE:O), Coca-Cola (NYSE:KO), Linn Co, LLC (NASDAQ:LNCO), Wal-Mart (NYSE:WMT), Cisco (NASDAQ:CSCO), Bristol-Myers Squibb (NYSE:BMY), Healthcare Select Sector SPDR (NYSEARCA:XLV), and General Dynamics (NYSE:GD).

Hedging Basics

In an effort to keep it as simple as possible, let me start with a brief definition from Investopedia:

"Making an investment to reduce the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting position in a related security, such as a futures contract."

Here is an example:

"An example of a hedge would be if you owned a stock, then sold a futures contract stating that you will sell your stock at a set price, therefore avoiding market fluctuations. )."

Investors use this strategy when they are unsure of what the market will do. A perfect hedge reduces your risk to nothing (except for the cost of the hedge.) Personally, I have not found the "perfect hedge" (outside of selling everything and going to cash, of course). If anyone has, please let us know about it right here in the comments section. However, there are some decent ones that do deserve our consideration.

In looking at a bunch of easy to understand strategies for hedging, I have narrowed the massive list down to the ones I happen to think are appropriate for the average individual investor.

Trying To Keeping It Simple

Having a diverse portfolio with allocations across many different business sectors is perhaps the most popular way for individual investors to "hedge". It is not the best way however, because in a serious downturn, basically everything gets hammered and investors flee to "safety".

As long as I can remember, the flight to safety has meant going into bonds, or bond funds. Haven't we all learned that when stocks go up, bonds go down, and when stocks go down, bonds go up? These days we live in a different world however, and the yields on bonds or bond funds (not junk bonds), have gone down and the principal price of the bond or bond fund themselves have gone up so high that many people, even some professionals, believe we could be heading into a bond bubble. Some investors believe that intermediate bond funds such as Metropolitan West Total Return (MWTRX) or Pimco Total Return D (PTTDX) are good answers to mitigate equity downdrafts.

Since these excellent funds are highly rated and offer their own yields of 3.50%-4.00%, there are many folks who gravitate towards them. I submit that their NAV has increased to a point where there could be a risk of total return loss, even though they pay very nice dividends. That being said, both of these funds have very strong track records and deserve consideration. Remember however, that an investor will require to actually buy the funds and the amount invested in these types of funds takes away from our investments in the core stocks we own, unless we have enough cash reserves to actually invest enough in them.

The other asset class that deserves to be considered are the inverse ETFs, which are actually "shorting" vehicles that can be used for certain index funds. The most popular of these would be ProShares Short QQQ (NYSEARCA:PSQ) which shorts the NASDAQ, ProShares Short S&P 500 (NYSEARCA:SH) which shorts the S&P 500, and ProShares Short Dow30 (NYSEARCA:DOG) which shorts the Dow Industrials index.

These can be purchased just like any stock, and will give an investor a broad range of hedging. They happen to be quite volatile and an investor needs to be nimble and to monitor them closely to have a positive affect on an overall portfolio. There are options available in these vehicles, so leverage can be used in that regard, and might be considered for some savvy investors.

The easiest way I have ever known to hedge my positions has been to simply buy put options in the stock or stocks I want to protect. They offer the flexibility and the liquidity for any investor to easily own and sell when events dictate. Yes, they require the same monitoring as the underlying stocks do, and while that sounds like a lot more work, it actually is not that bad as long as you are already in tune with what is going on with your stocks anyway. Just as important is the costs involved; buying put options on selected stocks is a fraction of the cost of either inverse ETFs or intermediate bond funds, and are far less risky than actually taking short positions in individual stocks as well.

Buying put options in selected stocks is what I would suggest for our Team Alpha portfolio.

Actions To Consider

I will not say that I suggest that these actions be taken. I will simply say for you to look at them and consider them. Maybe they are right for you, and perhaps they are not. The important thing is that you make yourself aware of these options and at the very least get comfortable with the idea.

If I were to hedge the Team Alpha portfolio, I would look at General Electric (GE), Johnson & Johnson (JNJ), Exxon Mobil (XOM), General Dynamics (GD), Procter & Gamble (PG), Coca-Cola (KO), Wal-Mart (WMT), and Bristol-Myers Squibb (BMY) as the positions I would want to hedge. These stocks are subject to corrections and downturns as are any other stocks, but they are also the largest positions within the portfolio.

Keep in mind that we can never offset losses completely this way, we can only limit the downside. In return, we hold our positions and collect the dividends as well. Take a look at the following put options to consider:

21.00GE130119P000210000.76Down 0.030.780.7941224,983
70.00JNJ130119P000700001.55Up 0.171.561.591338,861
87.50XOM130119P000875001.83Up 0.171.791.8115212,603
67.50GD130119P000675002.30Up 0.502.352.4567618
67.50PG130119P000675001.45Up 0.321.441.4523126,363
36.25KO130119P000362500.88Up 0.140.900.9218815,996
72.50WMT130119P000725002.06Down 0.092.012.03705,577
33.00BMY130119P000330001.15Up 0.251.111.134007,569

All of these put options expire in January. They are very much like short term "insurance" against sudden drops in the underlying stocks. If the stocks drop precipitously, the puts will increase in value, mitigating some losses.

It is my belief that the market could take a deep breath a few days after the election. It might jump up just after, but between tax selling season and the fiscal cliff questions, we could see a pullback. This short term hedging strategy can offer some downside protection in the event of a sudden sell off after Washington D.C. gets back to normal.

As of this writing, the cost to buy these puts for the Team Alpha portfolio is roughly $1600 plus commissions. The options will begin decaying quickly, after the November expiration, but by that time, or the latest early December, I believe any correction we might have would be over, as various issues get addressed by the powers that be.

Even if the options were to expire worthless, we would own our shares, collect our dividends, and probably have some added peace of mind IF the bottom drops out in these stocks in the next 30-45 days or so. This strategy will not cover all losses in the entire portfolio, but it could certainly soften the blow.

To me, this seems to be the simplest, and most cost effective way to hedge for a short period of time. It is not perfect and could backfire, but the entire loss would be the $1600 spent on the put options. More about hedging in future articles, but I would enjoy some feedback on your hedging thoughts and ideas.

Source: Retirement Strategies: To Hedge Or Not To Hedge, That Is The Question