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Summary An investor can “bullet-proof” his portfolio while maximizing his expected return using the hedged portfolio method. When creating a hedged portfolio, you can start from scratch or start with a list of stock picks. We explore the second method here. The stock picks we start with are ones with promising social data metrics, as determined by Likefolio, a startup that uses social media to measure sentiment about brands. We provide a sample hedged portfolio of top Likefolio stocks designed for an investor unwilling to risk a drawdown of more than 20%. Using Social Data To Gauge Market Sentiment Several years ago, one of the early pioneers in using social media data for investment purposes was London-based Derwent Capital Markets, which launched a hedge fund in 2011 using Twitter (NYSE: TWTR ) data to gauge market sentiment. The idea for the fund came from a research paper by Johan Bollen, Huina Mao, and Xiao-Jun Zeng that claimed to have found a method of using Twitter data to determine the daily direction of Dow Jones Industrial Average with 87.6% accuracy. Derwent’s Twitter hedge fund was shut down, shortly after opening, prompting Martin Bryant of The Next Web to comment : it appears that there simply isn’t much market appetite for investments powered by social media sentiment. It seems that the market simply isn’t ready to put its faith in the wisdom of digital crowds just yet. Bryant may have spoken too soon. Today, both institutional investors as well as retail investors are using social data aggregated by Likefolio (for example, TD Ameritrade (NYSE: AMTD ) now offers its retail customers social data provided by Likefolio, as AMTD managing director Nicole Sherrod explains in this Fox Business interview). Unlike earlier approaches such as Derwent Capital’s short-lived fund, Likefolio’s approach isn’t to gauge market sentiment directly, but to gauge sentiment about brands that roll up to publicly traded stocks. Using Social Data To Source Stock Ideas There’s a lot of chatter on social media about individual stocks, but a challenge with generating any useful data from it is the tendency of an investor to ” talk his book “: anyone who is long a particular stock is likely to make bullish comments about it, and vice-versa. Likefolio avoids this challenge by mining comments about brands owned by publicly traded companies, rather than the stocks themselves, as the image above from its website illustrates. Someone who comments about Yum Brands (NYSE: YUM ) on Facebook (NASDAQ: FB ), Twitter, or other social media platforms, may be talking his book, but, for every YUM investor there are many more Taco Bell, KFC, and Pizza Hut customers, and they are sharing their thoughts about those brands on social media constantly (to see an example for yourself, enter “Taco Bell” in the search field on Twitter now, and click the “Live” tab). According to Likefolio, a drop in social data sentiment and volume on Yum Brands offered a warning in late June that was confirmed by the company’s dissappointing earnings release in October. The Risks of Investing in Social Data-Sourced Stocks As with any style of stock investing, when using social data to source stock picks, you face two kinds of risks: idiosyncratic risk , the risk of something bad happening to one of the companies you own, and market risk , the risk of your investments suffering due to a decline of the market as a whole. Two Ways of Limiting Stock-Specific Risk One way to limit stock-specific risk is via hedging; another way is via diversification. In a previous article (“How to Limit Your Market Risk”), we discussed ways to limit market risk for a diversified portfolio. In this post, we’ll look at how to “bulletproof” a concentrated portfolio of top Likefolio stocks using the hedged portfolio method . In that method, you limit both stock-specific and market risk via hedging. Top Likefolio Stocks In a recent post (“5 Stocks with Sizzling Social Data Metrics”), Likefolio co-founder Andy Swan highlighted five stocks for which social data trends were strongly bullish: Michael Kors Holdings (NYSE: KORS ) Amazon (NASDAQ: AMZN ) Crocs (NASDAQ: CROX ) Walmart (NYSE: WMT ) GoPro (NASDAQ: GPRO ) We’ll use those stocks as a starting point to construct a “bulletproof”, or hedged portfolio for an investor who is unwilling to risk a drawdown of more than 20%, and has $400,000 that he wants to invest. First, though, let’s address the issue of risk tolerance, and how it affects potential return. Risk Tolerance and Potential Return All else equal, with a hedged portfolio, the greater an investor’s risk tolerance — the greater the maximum drawdown he is willing to risk (his “threshold”, in our terminology) – the higher his potential return will be. So, we should expect that an investor who is willing to risk a 25% decline will have a chance at higher potential returns than one who is only willing to risk a 15% drawdown. In our example, we’ll be splitting the difference and using a 20% threshold. Constructing A Hedged Portfolio We’ll outline the process here briefly, and then explain how you can implement it yourself. Finally, we’ll present an example of a hedged portfolio that was constructed this way with an automated tool. The process, in broad strokes, is this: Find securities with promising potential returns (we define potential return as a high-end, bullish estimate of how the security will perform). Find securities that are relatively inexpensive to hedge. Buy a handful of securities that score well on the first two criteria; in other words, buy a handful of securities with high potential returns net of their hedging costs (or, ones with high net potential returns). Hedge them. The potential benefits of this approach are twofold: If you are successful at the first step (finding securities with high potential returns), and you hold a concentrated portfolio of them, your portfolios should generate decent returns over time. If you are hedged, and your return estimates are completely wrong, on occasion — or the market moves against you — your downside will be strictly limited. How to Implement This Approach Finding promising stocks In this case, we’re going to start with the five stocks mentioned in the Likefolio blog post we linked to above. To quantify potential returns for these stocks, you can, for example, use analysts’ consensus price targets for them, to calculate potential returns in percentage terms. For example, via Nasdaq’s website , the image below shows the sell-side analysts’ consensus 12 month price target for AMZN as of October 9th, 2015: Since AMZN closed at $539.80 on October 9th, the consensus price target suggests a 20% potential return over 12 months. In general, though, you’ll need to use the same time frame for each of your potential return calculations to facilitate comparisons of potential returns, hedging costs, and net potential returns. Our method starts with calculations of six-month potential returns. Finding inexpensive ways to hedge these securities Whatever hedging method you use, for this example, you’d want to make sure that each security is hedged against a greater-than-20% decline over the time frame covered by your potential return calculations (our method attempts to find optimal static hedges using collars as well as protective puts going out approximately six months). And you’ll need to calculate your cost of hedging as a percentage of position value. Select the securities with highest, or at least positive net potential returns When starting from a large universe of securities, you’d want to select the ones with the highest potential returns, net of hedging costs. In this case, we’re starting with just a handful of securities, but we’ll at least want to exclude any of them that has a negative potential return net of hedging costs. It doesn’t make sense to pay X to hedge a stock if you estimate the stock will return 70% over 6 months, maybe it’s worth it to you to pay up to hedge your downside risk. Despite the high cost of the GPRO hedge, the overall hedging cost of the portfolio is negative. Possibly More Protection Than Promised In some cases, hedges such as the GPRO one, or the other ones in the portfolio above can provide more protection than promised. For an example of that, see this instablog post on hedging the iPath S&P 500 VIX ST Futures ETN (NYSEARCA: VXX ). [i] To be conservative, this optimal collar shows the puts being purchased at their ask price, and the calls being sold at their bid price. In practice, an investor can often buy the puts for less (i.e., at some point between the bid and ask prices) and sell the calls for more (again, at some point between the bid and ask). So the actual cost of opening this collar would have likely been less.