Tag Archives: potential

A Checklist To Save Your Assets

Summary There are two risks associated with stock investing: idiosyncratic risk, and market risk. Checklists of fundamental analysis questions protect against neither. To limit your risk, you need a checklist with just two questions on it: “Am I diversified?” and “Am I hedged?” Diversification can protect you against idiosyncratic risk; hedging can protect you against both idiosyncratic risk and market risk. We show how to build a portfolio that protects against both risks and present a sample protected portfolio. The Checklist Manifesto Last December, as I sat hooked up to intravenous lines in the pre-op room of a surgical center, my orthopedist stopped to check in before I went under. I asked him if he remembered which shoulder he was supposed to operate on, and he took a magic marker and drew an arrow on my right shoulder, near the arrow a nurse had me mark there earlier, with my good arm. That point of that was to avoid an “error of ineptitude”, as surgeon and author Atul Gawande , MD, MPH, terms it. Avoiding errors of ineptitude, by using checklists, was the subject of Dr. Gawande’s 2009 bestseller, The Checklist Manifesto , pictured below. Checklist Investing The seed for Gawande’s book was his New Yorker article published at the end of 2007 (“The Checklist”). In a January, 2013 interview with Motley Fool (“Checklist Investing: How to Avoid Errors and Learn From Mistakes”), hedge fund manager Mohnish Pabrai discussed how that initial article influenced him, and caused him to reach out to Atul Gawande, who later included him in his book: I think after I got my head handed to me in 2008, the funds were down 60%; I think one of them was more than 60% in 2008, and the markets were down 38% or so, so we underperformed the markets by some margin in 2008. So I did a lot of soul searching on what I was missing, and I happened at the time to read a book by Atul Gawande; actually, I read an article first in The New Yorker , which was on the checklist, where he applied it to the medical field, and then subsequent to that, I had conversations with Atul, and he actually made it into a book called The Checklist Manifesto… Pabrai went on to note in that interview that he had developed a checklist with “97 or 98” fundamental analysis questions on it. Presumably, Pabrai went through those 97 or 98 questions before adding to his Horsehead Holdings (NASDAQ: ZINC ) stake in October of 2013. Here’s a look at how ZINC has traded since then. As of last quarter, Pabrai’s Dalal Street, LLC was the largest institutional holder of ZINC, with over 11% of its shares. Checklists Don’t Limit Risk Like the margin of safety concept, 98-question checklists may be helpful for security selection. They just don’t limit either of the two kinds of risk associated with stock investing: 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. A Two Question Checklist Here is a simple, two question checklist to determine if you are protected against idiosyncratic, or stock-specific risk: Am I diversified? Am I hedged? If you’re diversified, than the impact to your portfolio of a decline in one stock is limited to the percentage of your portfolio allocated to that stock. So, for example, if you have 20 equal-weighted stocks, and one loses 50% of its value, all else equal, your portfolio would be down by 2.5% (since you had 5% allocate to each stock, and 0.5 x 5 = 2.5). If your idiosyncratic risk is covered by diversification, you can use a simple form of hedging to limit your market risk . According to the article linked to above, though, ZINC was one of only 6 stocks in Pabrai’s portfolio in 2013, so he was running a concentrated portfolio, rather than a diversified one. In a concentrated portfolio, since diversification isn’t limiting your idiosyncratic risk, you can use hedging to limit both idiosyncratic and market risk. The hedged portfolio method offers a way to do that while maximizing your expected return. Below we’ll run through the process of creating a hedged portfolio to limit both idiosyncratic and market risk, and provide an example. First, we need to note the tradeoff between risk tolerance and expected return. Risk Tolerance, Hedging Cost, And Expected 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”) – the higher his expected return will be. So, for example, an investor willing to risk a decline of 28% would likely have a higher expected return than one willing to risk a decline of only 8%. We’ll split the difference below, and construct a hedged portfolio for an investor who is willing to risk a decline of no more than 18%, and has $200,000 to invest. Constructing A Hedged Portfolio The process, in broad strokes, is this: Find securities with high 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 securities with high potential returns For this, you can use Seeking Alpha Pro , among other sources. Seeking Alpha articles often include price targets for long ideas, and you can convert these to percentage returns from current prices. But you’ll need to use the same time frame for each of your expected return calculations to facilitate comparisons of expected returns, hedging costs, and net expected returns. Our method starts with calculations of six-month potential returns. Finding Securities That Are Relatively Inexpensive To Hedge For this step, you’ll need to find hedges for the securities with high potential returns, and then calculate the hedging cost as a percentage of position value for each security. Whatever hedging method you use, for this example, you’d want to make sure that each security is hedged against a greater-than-18% 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. Buying Securities That Score Well On The First Two Criteria To determine which securities these are, you may need to first adjust your potential return calculations by the time frame of your hedges. For example, although our method initially calculates six-month potential returns and aims to find hedges with six months to expiration, in some cases the closest hedge expiration may be five months out. In those cases, we will adjust our potential return calculation down accordingly, because we expect an investor will exit the position shortly before the hedge expires (in general, our method and calculations are based on the assumption that an investor will hold his shares for six months, until shortly before their hedges expire or until they are called away, whichever comes first). Next, you’ll need to subtract the hedging costs you calculated in the previous step from the potential returns you calculated for each position, and sort the securities by their potential returns net of hedging costs, or net potential returns. The securities that come to the top of that sort are the ones you’ll want to consider for your portfolio. Fine-Tuning Portfolio Construction You’ll want to stick with round lots (numbers of shares divisible by 100) to minimize hedging costs. Another fine-tuning step is to minimize cash that’s leftover after you make your initial allocation to round lots of securities and their respective hedges. Because each security is hedged, you won’t need a large cash position to reduce risk. And since returns on cash are so low now, by minimizing cash you can potentially boost returns. In this step, our method searches for what we call a “cash substitute”: that’s a security collared with a tight cap (1% or the current yield on a leading money market fund, whichever is higher) in an attempt to capture a better-than-cash return while keeping the investor’s downside limited according to his specifications. You could use a similar approach, or you could simply allocate leftover cash to one of the securities you selected in the previous step. Calculating An Expected Return While net potential returns are bullish estimates of how well securities will perform, net of their hedging costs, expected returns, in our terminology, are the more likely returns net of hedging costs. In a series of 25,412 backtests over an 11-year time period, we determined two things about our method of calculating potential returns: it generates alpha, and it overstates actual returns. The average actual return over the next six months in those 25,412 tests was 0.3x the average potential return calculated ahead of time. So, we use that empirically derived relationship to calculate our expected returns. An Automated Approach Here we’ll show an example of creating a hedged portfolio using the general process described above, facilitated by the automated hedged portfolio construction tool at Portfolio Armor . In the first field below, we’re given the choice of entering our own ticker symbols. Instead, we’ll leave that field blank, and let the site pick its own securities for us. In the second field, we enter the dollar amount of our investor’s portfolio (200000), and in the third field, the maximum decline he’s willing to risk in percentage terms (18). Next, we clicked the “create” button. A couple of minutes later, we were presented with the hedged portfolio below. The data here is as of Thursday’s close. Worst-Case Scenario The “Max Drawdown” column in the portfolio level summary shows the worst-case scenario for this hedged portfolio. If every underlying security in it went to zero before the hedges expired, the portfolio would decline 16.94%. Negative Hedging Cost Note that, in this case, the total hedging cost for the portfolio was negative, -0.12%, meaning the investor would receive more income in total from selling the call legs of the collars on his positions than he spent buying the puts. Best-Case Scenario At the portfolio level, the net potential return is 15.21%. This represents the best-case scenario, if each underlying security in the portfolio meets or exceeds its potential return. A More Likely Scenario The portfolio level expected return of 5.97% represents a more conservative estimate, based on the historical relationship between our calculated potential returns and actual returns. Each Security Is Hedged Note that in the portfolio above, each underlying security is hedged. BofI Holding (NASDAQ: BOFI ), JetBlue Airways (NASDAQ: JBLU ), Sketchers, USA (NYSE: SKX ), and Tyler Technologies (NYSE: TYL ) are hedged with optimal collars with their caps set at their respective potential returns. Amazon.com (NASDAQ: AMZN ) is hedged as a cash substitute, with an optimal collar with its cap set at 1%. Hedging each security according to the investor’s risk tolerance obviates the need for broad diversification, and lets him concentrate his assets in a handful of securities with high potential returns net of their hedging costs. Here’s a closer look at the hedge for one of these positions, JBLU: As you can see in first part of the image above, JBLU is hedged with an optimal collar with its cap set at 20.87%, which was the potential return Portfolio Armor calculated for the stock: the idea is to capture the potential return while offsetting the cost of hedging by selling other investors the right to buy JBLU if it appreciates beyond that over the next six months. The cost of the put leg of this collar was $1,950, or 4.93% of position value, but, as you can see in the image below, the income from the short call leg was $1,425, or 3.6% as percentage of position value. Since the income from the call leg offset some of the cost of the put leg, the net cost of the optimal collar on ISRG was $525, or 1.33% of position value.[i] Note that, although the cost of the hedge on this position was positive, the hedging cost of this portfolio as a whole was negative . Why These Particular Securities? Portfolio Armor doesn’t use a 98-question checklist to rank its universe of securities, which consists of every hedgeable security traded in the U.S. It looks at two factors to estimate potential returns: price history, and option market sentiment. Then it subtracts hedging costs to calculate potential returns net of hedging costs, or net potential returns. The securities included in this portfolio had some of the highest net potential returns in Portfolio Armor’s universe on Thursday. Possibly More Protection Than Promised In some cases, hedges such as the ones in the portfolio above can provide more protection than promised. For an example of that, see this recent instablog post on hedging Tesla (NASDAQ: TSLA ). Hedged Portfolios For More Risk-Averse Investors The hedged portfolio shown above was designed for an investor who could tolerate a decline of as much as 18% over the next six months, but the same process can be used for investors who are even more risk-averse, willing to risk drawdowns of as little as 2%. —————————————————————————– Notes: [i] To be conservative, the net cost of the collar was calculated using the bid price of the calls and the ask price of the puts. In practice, an investor can often sell the calls for a higher price (some price between the bid and ask) and he can often buy the puts for less than the ask price (again, at some price between the bid and ask). So, in practice, the cost of this collar would likely have been lower. The same is true of the other hedges in this portfolio, the costs of which were also calculated conservatively.

There Is No Margin Of Safety

Summary Value investing’s “margin of safety” is illusory: “50 cent dollars” can turn into “50 cent quarters”, or worse. You can use value investing in security selection, but to protect against stock-specific risk, you need to diversify or hedge. An advantage of hedging is that it let’s you concentrate your assets in a handful of stocks you think will do best, while limiting your downside risk. An additional advantage of hedging is that it protects against market risk, which diversification alone does not. We outline a method for creating a hedged portfolio of value stocks, and provide an example. The Margin of Safety in Value Investing One of key terms used in value investing is ” margin of safety “, which refers to difference between a company’s market price and its ” intrinsic value “, as illustrated by the image below (take from the website of Pratt Capital, LLC) Margin of safety was coined by the putative father of value investing, Benjamin Graham, and perhaps the best way to help explain it is quote one of his famous sayings, “In the short run, the market is a voting machine, but in the long run, it’s a weighing machine”. “Voting”, or investor sentiment, drives the market price in the short term, according to Graham, but “weighing”, or recognition of intrinsic value, drives the stock price in the long term. The idea is, essentially, to buy a stock when it’s trading for less than it’s really worth (its intrinsic value), and sell it at some future date when it’s trading at its intrinsic value or higher. The Margin of Safety in Reality Buying a stock for less than your estimation of its intrinsic value and selling it for more later – value investing, in a nutshell – makes perfect sense. What doesn’t make sense is calling that discount between the market price and your estimation of intrinsic value a “margin of safety”, because it isn’t one. Let’s take the simplest case, what Graham referred to as a ” net-net “, a stock trading for less than its net current assets minus its total liabilities. In Graham’s day, these were more common, but you can still find them occasionally today among very small stocks. A stock trading for 50 cents per share with $1 per share in net current assets minus total liabilities would be a classic “50 cent dollar”. A can’t lose proposition, right? Well, not quite. One problem with a so-called 50 cent dollar is that you really don’t know what the net current assets are now ; you only know what they were as of the date they were reported. What if next time the company reports they have only 50 cents in net current assets per share? All else equal (i.e., the same conditions causing it to sell at discount in the past still applying) the share price will tank. And all else may end up being worse. Diversification versus Margin of Safety Of course, Graham knew this, which is why he advocated buying a basket of net-nets, rather than just a few. The basket — i.e., diversification — was his real downside protection against the stock-specific risk of some of his 50 cent dollars turning out to be a 50 cent half dollars, or, worse, a 50 cent quarters. One could argue that value investors today using more subjective measures of intrinsic value based on estimates of future earnings should be even more concerned about downside protection, particularly after some prominent value investing debacles during the last financial crisis. The Limits of Diversification Although diversification protects against stock-specific risk, it doesn’t protect against market risk. When the market tanks, nearly all stocks tank too. We saw this in miniature last month, as we noted in an article published soon after (“Lessons from Monday’s Market Meltdown”), and of course we saw it in 2008 , when stocks were a sea of red across the globe. What offers protection against market risk is hedging. Hedging Against one Kind of Risk or Both You can use a diversified portfolio to limit your stock-specific risk, and hedge against market risk by buying optimal puts on relevant index ETFs. We offered a step-by-step example of that in a previous post (“Protecting A Million Dollar Portfolio”). Alternatively, you can hedge each security you own; if you do that, you are hedging against both market risk and stock-specific risk, so you’ve obviated the need for broad diversification. That enables you to aim for maximizing your potential return with a concentrated, hedged portfolio. You can still use value investing principles to construct that portfolio, but you won’t be relying on an illusory “margin of safety” to protect it. We demonstrate a way of doing that below. 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 returns than one who is only willing to risk, say, a 15% drawdown. For the purposes of this example, we’ll split the difference and create a hedged portfolio designed for an investor with $250,000 who is willing to risk a drawdown of no more than 20%. Constructing A Hedged Portfolio We’ll summarize process the hedged portfolio process here, 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 high 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 use a large cap value screen from Zack’s Investment Research, but you could also use value stock ideas from Seeking Alpha or Seeking Alpha Pro . To quantify potential returns for these stocks, you can, for example, use analysts’ price targets for them and then convert these to percentage returns from current prices. 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 First, you’ll need to determine whether each of these top holdings are hedgeable. Then, 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. Selecting the securities with highest net potential returns In order to determine which securities these are, out of the list above, you may need to first adjust your potential return calculations by the time frame of your hedges. For example, although our method initially calculates six-month potential returns and aims to find hedges with six months to expiration, in some cases the closest hedge expiration may be five months out. In those cases, we will adjust our potential return calculation down accordingly, because we expect an investor will exit the position shortly before the hedge expires (in general, our method and calculations are based on the assumption that an investor will hold his shares for six months, until shortly before their hedges expire or until they are called away, whichever comes first). Next, you’ll need to subtract the hedging costs you calculated in the previous step from the potential returns you calculated for each position, and exclude any security that has a negative potential return net of hedging costs. Fine-tuning portfolio construction You’ll want to stick with round lots (numbers of shares divisible by 100) to minimize hedging costs, so if you’re going to include a handful of securities from the sort in the previous step and you have a relatively small portfolio, you’ll need to take into account the share prices of the securities. Another fine-tuning step is to minimize cash that’s leftover after you make your initial allocation to round lots of securities and their respective hedges. Because each security is hedged, you won’t need a large cash position to reduce risk. And since returns on cash are so low now, by minimizing cash you can potentially boost returns. In this step, our method searches for what we call a “cash substitute”: that’s a security collared with a tight cap (1% or the current yield on a leading money market fund, whichever is higher) in an attempt to capture a better-than-cash return while keeping the investor’s downside limited according to his specifications. You could use a similar approach, or you could simply allocate leftover cash to one of the securities you selected in the previous step. Calculating Expected Returns While net potential returns are bullish estimates of how well securities will perform, net of their hedging costs, expected returns, in our terminology, are the more likely returns net of hedging costs. In a series of 25,412 backtests over an 11-year time period, we determined two things about our method of calculating potential returns: it generates alpha, and it overstates actual returns. The average actual return over the next six months in those 25,412 tests was 0.3x the average potential return calculated ahead of time. So, we use that empirically derived relationship to calculate our expected returns. An Automated Approach Here we’ll show an example of creating a hedged portfolio starting with value stocks using the general process described above, facilitated by the automated hedged portfolio construction tool at Portfolio Armor . Narrowing Down Our List of Stocks To get a starting list of value stocks, we used the Large Cap Value screen created by Zack’s Investment Research in Fidelity ‘s stock screener. That screen uses these criteria: Market capitalization of $5 billion and above Projected EPS growth (quarter over quarter) of 17% or more Projected EPS growth (year over year) of 17% or more P/E below 12 PEG below 1 Security price above $5 Average volume over 50,000 shares traded daily On Thursday, that screen generated these 11 stocks: American Airlines Group (NASDAQ: AAL ) Citigroup (NYSE: C ) Delta Air Lines (NYSE: DAL ) Ford Motor Co. (NYSE: F ) Gilead Sciences (NASDAQ: GILD ) HollyFrontier Corp (NYSE: HFC ) Lear Corp (NYSE: LEA ) Southwest Airlines (NYSE: LUV ) Tesoro Corp (NYSE: TSO ) United Continental Holdings (NYSE: UAL ) Valero Energy (NYSE: VLO ) Using the Automated Tool In the first step, we enter the eleven ticker symbols in the “Tickers” field, the dollar amount of our investor’s portfolio (250000) in the field below that, and in the third field, the maximum decline he’s willing to risk in percentage terms (20). In the second step, we are given the option of entering our own potential return estimates for each of these securities. Instead, in this case, we’ll let Portfolio Armor supply its own potential returns. Note that the site’s potential returns are calculated based on price history and option market sentiment, so they generally won’t be very high for value stocks. But, again, you can enter your own potential returns in this step if you want. A couple minutes after clicking the “Create” button, we were presented with the hedged portfolio below. The data here is as of Thursday’s close. Why These Particular Securities? The site included all of the entered securities for which it calculated a positive potential return, net of hedging costs. In this case, that turned out to be six of the eleven stocks we entered, DAL, GILD, HFC, LEA, TSO, and VLO. In its fine-tuning step, it added Under Armour (NYSE: UA ) as a cash substitute. Let’s turn our attention now to the portfolio level summary for a moment. Worst-Case Scenario The “Max Drawdown” column in the portfolio level summary shows the worst-case scenario for this hedged portfolio. If every underlying security in it went to zero before their hedges expired, the portfolio would decline 19.8%. Negative Hedging Cost Note that, in this case, the total hedging cost for the portfolio was negative, -2.56%, meaning the investor would receive more income in total from selling the call legs of the collars on his positions than he spent buying the puts. That also means that if the underlying securities returned 0% over the next 6 months, and the hedges expired worthless, the portfolio would return 2.56% (to be prudent, we suggest exiting positions just before their hedges expire instead). Best-Case Scenario At the portfolio level, the net potential return is 6.32% over the next six months. This represents the best-case scenario, if each underlying security in the portfolio meets or exceeds its potential return. A More Likely Scenario The portfolio level expected return of 2.22% represents a conservative estimate, based on the historical relationship between our calculated potential returns and backtested actual returns. By way of comparison, a hedged portfolio created recently using the same decline threshold (20%), but without entering any ticker symbols (i.e., letting Portfolio Armor pick all the securities), had an expected return of 6.1%. You can see that hedged portfolio in a recent article (“Investing While Guarding Against Extensive Vertical Losses”). Each Security Is Hedged Note that each of the above securities is hedged. Under Armour, the cash substitute, is hedged with an optimal collar with its cap set at 1%, and the remaining securities are hedged with optimal collars with their caps set at each underlying security’s potential return, as calculated by the site. Here is a closer look at the hedge for Gilead Sciences: Gilead Sciences is capped here at 10.62%, because that’s the potential return Portfolio Armor calculated for it over the next several months. As you can see at the bottom of the image above, the cost of the put protection in this collar is $464, or 2.08% of position value. But if you look at the image below, you’ll see the income generated from selling the calls is $640, or 2.87% of position value. So, the net cost of this optimal collar is -$176, or -0.79% of position value, meaning the investor would collect more income from selling the calls than he paid to buy the puts.[i] Possibly More Protection Than Promised In some cases, hedges such as the 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. That’s true of the other hedges in this portfolio as well. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Investing While Guarding Against Extensive Vertical Losses

Summary Portfolio Manager and economist John Hussman warns that “extensive vertical losses” can follow a partial recovery from a correction similar to our recent one. One way to remain invested while guarding against extensive vertical losses is with the hedged portfolio method, which we outline here. We also present an example of a hedged portfolio designed for an investor with $200,000 who is unwilling to risk losses greater than 20%. Hussman Says We’re Due On Twitter (NYSE: TWTR ) earlier this month, the pseudonymous Florida-based trader StockCats shared the following chart, first posted a year earlier: The next day, the creator of the image, portfolio manager, Stanford Ph.D., and former finance professor John Hussman responded: In his next weekly market commentary (“That was not a crash”), Hussman updated his bearish sentiment: The market decline of recent weeks was not a crash. It was merely an air-pocket. It was probably just a start. Actual market crashes involve a much larger and concerted shift toward investor risk-aversion, which doesn’t really happen right off of a market peak. Historically, market crashes don’t even start until the market has first retreated by 10-14%, and then recovers about half of that loss, offering investors hope that things have stabilized (look for example at the 1929 and 1987 instances). The extensive vertical losses that characterize a crash follow only after the market breaks that apparent “support,” leading to a relentless free-fall that inflicts several times the loss that we’ve seen in recent weeks. If you were certain Hussman was right that the recent correction has just been an “air pocket,” and we’re due for worse, then an appropriate course of action might be to get out of the market. But as strong a case as Hussman makes, he’s been making a similar one for years. And even he doesn’t go so far as to predict exactly when he expects we’ll get the crash we’re due to get. So we’re left with the question of how to invest given the uncertainty of whether the long bull market will resume or we’ll soon be faced with Hussman’s ominous “extensive vertical losses.” Dealing With Uncertainty One way to deal with this sort of uncertainty is to invest in a handful of securities you think will do well, and hedge against the possibility that you end up being wrong. That approach is systematized in the hedged portfolio method, which we detailed in a previous post (“Backtesting The Hedged Portfolio Method”). One advantage of the hedged portfolio method is that it can accommodate a broad range of risk tolerances. Below, we’ll recap how you can build a hedged portfolio yourself (or for a client), and present an example of a hedged portfolio created for an investor with $200,000 to invest who can’t tolerate a drawdown of more than 20%. Risk Tolerance, Hedging Cost, 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”) – the lower his hedging cost will be and the higher his expected return will be. An investor who is willing to risk a 20% drawdown is in good company. Several years ago, in one of his earlier market commentaries , portfolio manager John Hussman had this to say about 20% drawdowns: “An intolerable loss, in my view, is one that requires a heroic recovery simply to break even… a short-term loss of 20%, particularly after the market has become severely depressed, should not be at all intolerable to long-term investors because such losses are generally reversed in the first few months of an advance (or even a powerful bear market rally).” Essentially, 20% is a large enough threshold that it can reduce the cost of hedging, but not so large that it precludes a recovery. Constructing A Hedged Portfolio The process, in broad strokes, is this: Find securities with high 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). Note that when creating a hedged portfolio for an extremely risk-averse investor, such as in this case, the second criteria (“inexpensive to hedge”) will outweigh the first (“high potential returns”) because it may not be possible to hedge the securities with the highest potential returns against such small declines. 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 securities with positive potential returns For this, you can use Seeking Alpha Pro , among other sources. Seeking Alpha articles often include price targets for long ideas, and you can convert these to percentage returns from current prices. But you’ll need to use the same time frame for each of your expected return calculations to facilitate comparisons of expected returns, hedging costs, and net expected returns. Our method starts with calculations of six-month potential returns. Finding Securities That Are Relatively Inexpensive To Hedge For this step, you’ll need to find hedges for the securities with positive potential returns, and then calculate the hedging cost as a percentage of position value for each security. Whatever hedging method you use, for this example, you’d want to make sure that each security is hedged against a greater than 4% 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. Buying Securities That Score Well On The First Two Criteria To determine which securities these are, you may need to first adjust your potential return calculations by the time frame of your hedges. For example, although our method initially calculates six-month potential returns and aims to find hedges with six months to expiration, in some cases the closest hedge expiration may be five months out. In those cases, we will adjust our potential return calculation down accordingly, because we expect an investor will exit the position shortly before the hedge expires (in general, our method and calculations are based on the assumption that an investor will hold his shares for six months, until shortly before their hedges expire or until they are called away, whichever comes first). Next, you’ll need to subtract the hedging costs you calculated in the previous step from the potential returns you calculated for each position, and sort the securities by their potential returns net of hedging costs, or net potential returns. The securities that come to the top of that sort are the ones you’ll want to consider for your portfolio. Fine-Tuning Portfolio Construction You’ll want to stick with round lots (numbers of shares divisible by 100) to minimize hedging costs. Another fine-tuning step is to minimize cash that’s left over after you make your initial allocation to round lots of securities and their respective hedges. Because each security is hedged, you won’t need a large cash position to reduce risk. And since returns on cash are so low now, by minimizing cash, you can potentially boost returns. In this step, our method searches for what we call a “cash substitute”: that’s a security collared with a tight cap (1% or the current yield on a leading money market fund, whichever is higher) in an attempt to capture a better than cash return while keeping the investor’s downside limited according to his specifications. You could use a similar approach, or you could simply allocate leftover cash to one of the securities you selected in the previous step. Calculating An Expected Return While net potential returns are bullish estimates of how well securities will perform, net of their hedging costs, expected returns, in our terminology, are the more likely returns net of hedging costs. In a series of 25,412 backtests over an 11-year time period, we determined two things about our method of calculating potential returns: it generates alpha, and it overstates actual returns. The average actual return over the next six months in those 25,412 tests was 0.3x the average potential return calculated ahead of time. So, we use that empirically derived relationship to calculate our expected returns. Example Of A Hedged Portfolio Here is an example of a hedged portfolio created using the general process described above by the automated portfolio construction tool at Portfolio Armor . With that tool, you just enter the dollar amount you are looking to invest (in this case, $200,000) and the largest drawdown you are willing to risk (your “threshold” – in this case, 20%), as in the image below, and the tool does the rest. Note that we left the “tickers” field blank above, because, in this case, we’re going to let the site pick all of the securities for us. But you can also start with your own investment picks when using this tool. We shared an example of that in a recent article (“Building a Bulletproof Stock Portfolio”). A couple of minutes after clicking the “create” button above, we were presented with the portfolio below, which was generated with data as of Friday’s close. Worst-Case Scenario The “Max Drawdown” column in the portfolio level summary shows the worst-case scenario for this hedged portfolio. If every underlying security in it went to zero before the hedges expired, the portfolio would decline 18.92%. Negative Hedging Cost Note that, in this case, the total hedging cost for the portfolio was slightly negative, -0.01%, meaning the investor would receive a few dollars more income in total from selling the call legs of the collars on his positions than he spent buying the puts. Best-Case Scenario At the portfolio level, the net potential return is 15.16%. This represents the best-case scenario, if each underlying security in the portfolio meets or exceeds its potential return. A More Likely Scenario The portfolio level expected return of 6.10% represents a more conservative estimate, based on the historical relationship between our calculated potential returns and actual returns. Each Security Is Hedged Note that in the portfolio above, each of the four primary underlying securities – Abiomed (NASDAQ: ABMD ), BofI Holding (NASDAQ: BOFI ), Expedia, Inc. (NASDAQ: EXPE ), and Sketchers, USA (NYSE: SKX ) – is hedged with an optimal collar capped at its potential return, and Amazon (NASDAQ: AMZN ) is hedged as a cash substitute, with its cap set at 1%. Hedging each security according to the investor’s risk tolerance obviates the need for broad diversification, and lets him concentrate his assets in a handful of securities with high net potential returns. Here’s a closer look at the hedge for one of these positions, ABMD: As you can see in the first part of the image above, ABMD is hedged with an optimal collar with its cap set at 21.92%, which was the potential return Portfolio Armor calculated for the stock: the idea is to capture the potential return while offsetting the cost of hedging by selling other investors the right to buy ABMD if it appreciates beyond that over the next six months. The cost of the put leg of this collar was $3,600, or 9.42% of position value, but as you can see in the image below, the income from the short call leg was $2,600, or 6.80% as a percentage of position value. Since the income from the call leg offset some of the cost of the put leg, the net cost of the optimal collar on ABMD was $1,000, or 2.62% of position value.[i] Note that, although the cost of the hedge on this position was positive, the hedging cost of this portfolio as a whole was slightly negative . Why These Particular Securities? As of Friday, all of these securities ranked among the top six names in the site’s universe when ranked by potential return net of hedging costs. Possibly More Protection Than Promised In some cases, hedges such as the 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 ). Hedged Portfolios For Even More Risk-Averse Investors The hedged portfolio shown above was designed for a small investor who could tolerate a decline of as much as 20% over the next six months, but the same process can be used for investors who are more risk averse. We presented an example of that in a recent article (“An Alternative To Cash For Risk-Averse Investors”). Note: [i] To be conservative, the net cost of the collar was calculated using the bid price of the calls and the ask price of the puts. In practice, an investor can often sell the calls for a higher price (some price between the bid and ask) and he can often buy the puts for less than the ask price (again, at some price between the bid and ask). So, in practice, the cost of this collar would likely have been lower. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.