Re-investing your Hedge Profits

by Wayne Ferbert on December 5th, 2011

As a Buy and Hedge investor, you are following Iron Rule #1: Hedge Every Investment. It is key to our investment approach. And as a do-it-yourself investor, being hedged is important to sleeping well at night.

When you hedge every investment, you eventually will have your hedges pay off. This is a market certainty. Over any long period of time, the markets eventually have a violent downward correction that happens, typically, in time frames as short as 1 to 3 months.

These market corrections are actually the SOURCE of ALPHA for the Buy and Hedge investor. Obviously, any investor that made profits from a hedge in 2008 and 2009 would have out-performed the market during those market downturns. Out-performing the market is the definition of alpha.

However, that out-performance is painful while it occurs. After all, the hedged investor likely lost money in the market – just not as much as the ‘next guy’ because he was hedged when the ‘next guy’ was not. The Buy and Hedge investor knows that he has protected his capital. And that is key to long-term out-performance (another key lesson from our book: Capital Lost is Capital that cannot grow).

The profits from the hedges represent significant out-performance for the Buy and Hedge investor. But if the Buy and Hedge investor just pockets the hedge profits and does not re-invest it, he will be leaving significant money on the table. The Buy and Hedge investor can put the power of compounding to work by re-investing the hedged profits.

Market history shows us that every violent and significant bear market of the last 50 years has been followed by a recovery to pre-bear market levels. Even the most recent 2008/2009 bear market has almost recovered fully – as the S&P 500 has nearly doubled from its low point of 667 in Spring 2009.

As a long term investor, you would have had your hedges in early 2009 make profits while your long-term positions would have been losing money. Because you are committed to the long term, you would have stayed invested in these long-term positions. And you would have kept rolling your hedges to new protection levels. But if you did not re-invest your hedged profits, these profits would have just sat in your portfolio as cash gains.

Instead, it is important to re-invest these hedge gains in to the underlying investments that you are invested in for the long term. This is especially key for the Buy and Hedge Investor since at least 50% of your portfolio is invested in Index Funds. In a falling market, this will feel very uncomfortable. Just remind yourself that you are hedged so these investments are controlled for downside exposure.

When you re-invest your hedged profits, you are forcing yourself to buy more shares – and almost always at a new lower price! This is a great discipline. Imagine if you had been purchasing more S&P 500 using your hedged profits at the $667 price back in Spring 2009. Those shares would now be worth $1250 – a 90%+ return! This is the power of compounding we talk about in our book.

Let’s use an example from 2008/2009 to make our point. Let’s say you had $100,000 invested in the S&P500 on January 3rd, 2008. The S&P500 was trading around $1440 on that day. We know it declined sharply in both the Fall of 2008 and again in the Spring of 2009 – eventually bottoming out at the aforementioned $667 price.

Your investment in the S&P 500 would have lost money in line with the market. However, your hedges would have paid off nicely. Depending on where you set your hedges, you would have probably protected your portfolio to the tune of about 20-25% of the downside. That 20% would have been worth around $20,000. Given the declining market, your average cost basis for re-investing those hedged profits likely would have been around $800-$900 in the S&P 500.

Examine the two scenarios: If you did not re-invest your hedged profits, your S&P500 investment would almost be back to even when you factor in the dividends paid. It would be down 8% roughly. And your $20,000 hedge profit would offset that and you’d be up around 12%. Not bad.

But if you re-invested your hedged profits at an average basis of around $900 in the S&P500, those new shares would be worth $1250 now – an increase of 39%! So, your $20,000 in hedged profits wouldn’t be sitting as cash – but would instead represent more shares of the S&P500 worth around $27,800 instead of $20,000.

You have to be disciplined to re-invest your hedged profits – and trust that after violent down markets shake out, they recover. And that recovery represents a chance to grow and compound your returns nicely.

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