Warren Buffett’s Rule #1 of investing is: “Don’t lose money” and the integral part of succeeding at Rule #1 is hedging one’s portfolio. The question then is: “How do we hedge our portfolios?”
In order to set a context for explaining strategies let’s briefly revisit the Golden Rule of Investing.
The Golden Rule of Investing
“The more uncertain you are about a position, the more you should hedge your position!”
This might be worth sticking right next to Phil’s favorite post-its that state:
“It is NOT my Job to Save the Market”
and:
"When in Doubt - Sell Half"
Before we figure out how to hedge, let’s evaluate how certain we are of the current direction of the market. On Monday Phil raised concerns over the pending $2Tn Deficit that is predicted that the energy sector would take us down this week (it did) even while calling a bottom on oil at $35 and looking to pick up stocks on our Buy List on the way down. Obviously the market itself is all over the place and, while we may guess well, we simply can’t be sure of the direction.
The VIX is a testimony to this, finishing the day at 46.11, still historically way above average and indicating tremendous amounts of market uncertainty. And we got the drop we were looking for this week and Phil extolled people to buy off THE LIST during both Wednesday and Thursday’s very scary sessions. When markets drop precipitously, traders generally fall into one of three categories;
[1] Panic Sellers [2] Knife catchers and [3] Hedged traders.
Panic sellers usually attain instant relief as fear overwhelms them, knife catchers usually experience prolonged pain as hope and greed outweigh fear while hedged traders usually operate at that intersection between greed and fear; they’ve seen it all before and nothing riles them – that’s us (in theory!).
Trying to time your entries and exits correctly is always a guessing game. Here’s a nice video discussing some chart patterns you can look for to identify fear and greed in the markets.
Since our portfolios are always hedged (or certainly should be!), we have much less fear of the market no matter which way it moves. Obviously after such a significant market downturn, fear is paramount, uncertainty is at a peak and hedging should be a trader’s top priority because as Phil once mentioned:
“Nobody wants you to get out of stocks, not your broker (he wants the commissions), not the media (if you don’t have stocks, why watch CNBC?), not the analysts (same ratings issue) and not the newsletter writers who want you to keep in the markets…
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