Saturday, March 17, 2012

In Praise of Hedging

Hedging against catastrophic loss is common-sense, and becomes more so as risk rises.

As a general observation, those with less wealth tend to be unhedged and those with more wealth tend to be hedged. In other words, hedging matters. Hedging has a clubby investment-speculation sound, but it basically means "insurance."

Since there is a risk your vehicle could be damaged in an accident or stolen, you buy auto insurance to limit your loss should either of those unfortunate but not uncommon "bad things" occur.

"Middle-class" people (i.e. those with some financial security) have auto insurance, while "poor" people (i.e. those with little financial security) often do not. Thus when the accident occurs, the person without the hedge suffers a potentially catastrophic loss. Without a car, they can't get to work, etc., and if they don't have enough cash or credit to buy another car, then they have become much, much poorer.

Auto insurance is not free; rather, it is very expensive, especially for young people, so the temptation to forego that expense is high. Having no insurance is "playing the odds," that is, betting that a bad thing won't happen. Since the consequences of not having a vehicle are high in the U.S., then that is an intriniscally risky bet because regardless of where you place the odds, the potential loss is significant.

Homeowners buy a fire insurance policy to protect their house against the risk of fire, but the cost of this insurance is typically a very small percentage of the potential loss or value of the home. Auto insurance, on the other hand, is often a significant percentage of the vehicle's value.

My point here is that as the cost of the hedge rises, it becomes more tempting to forego it and "play the odds." Since the cost of the hedge reflects the perceived risk, then this is a dangerous line of thinking. The more risk rises, the more valuable the hedge, as the risk of catastrophic loss is higher. Foregoing a hedge because it is costly exposes us to higher odds of a catastrophic loss.

Health insurance is in some ways the acme of middle-class status, as it is extremely costly and hedges America's horrendously costly healthcare (sickcare). My wife and I pay about $12,000 annually for stripped-down health insurance: no coverage for meds, eyewear or dental, $50 co-pay for any visit, etc. But since this is a Kaiser Permanente Plan (a non-profit provider), the co-pay for something serious like a heart attack is $500, regardless of the ultimate cost. In that sense it is an excellent hedge against catastrophic health expenses because we know our total cost of care will not exceed $13,000 annually for hospital care ($12K for the insurance and $500 each for a hospital stay/operation).

Medications, dental work and eyewear are however unhedged and must be paid in cash. (Don't forget to floss--that too is a hedge.)

Over a decade, we will pay $120,000 for the hedge against a $120,000 medical bill for a heart attack or other life-threatening event. We could just save the $120,000, and set this aside as the hedge, but then what happens if treatment costs $200,000? After all, in America $120,000 covers perhaps a week in the hospital and some common form of surgery. Anything more serious could cost much, much more.

On the other hand, since we're both healthy, then isn't the $120,000 a decade an excessively expensive hedge? That is the nature of hedges--they all look like a waste of money until they "work," i.e. protect against catastrophic loss.

This example reveals something important about hedging, which is that it is complex. Hedges that limit losses to a known amount tends to be costly, while partial hedges that protect against only catastrophic losses only tend to be less expensive. That level of uncertainty and risk is the cost of the hedge.

Since I am self-employed (and have been for most of my life), I am exposed to high levels of loss and risk on a daily basis (not to mention that my brother and I both lack the "take the safe route" gene), and so I have a lot of risk to juggle and hedge. I could buy a lower-cost health insurance plan with a high co-pay, but it's worth a premium to me to fix my total potential expense/loss.

That's just me; others will choose some other balance of risk and loss. The main point is that you get what you pay for in hedging.

The ultimate hedge against unknown risk is cash savings. Since humanity first developed the concepts of insurance, hedges and wealth stored in means-of-exchange objects such as gold coins, savings have been the ultimate hedge against risks known and unknown.

Grain stored in large clay pots is a hedge against a failed crop. It is also a form of savings, since it could be sold to cover some other unexpected event. Gold coins had the advantage of being smaller and indestructable, as least by mold and insects, though they also introduced the new risk of easy theft. (Predatory Central States could of course confiscate either the grain or the gold if it was known you possessed either asset.)

Since bad things happen with alarming regularity in life, those without hedges tend to suffer much greater losses than those who are hedged against potentially catastrophic loss. There is a positive-feedback aspect to hedging: "poor" people tend not to be hedged, so when bad things happen then their losses are catastrophic, further weakening their ability to buy hedges.
Those with more wealth tend to be fully hedged, so their losses are limited. This enables them to set aside more capital to invest in productive assets. (Unless of course they consume all their surplus income.) This accrued wealth generates more wealth, and so the hedged household's wealth tends to increase as their losses are fixed at a relatively modest level.

In the investment-speculation world, professionals tend to be hedged while amateurs are never hedged. This is a generalization, of course, but the moment the amateur hedges his positions then he is no longer an amateur.

For a variety of reasons, it is very easy to make unhedged speculations and very difficult to hedge every position as a matter of habit. One reason is that we all understand a long or short bet: we are betting the asset will rise or fall.

A hedge is not so easy to understand. A common hedge, for example, is to protect owning 1,000 shares of Engulf & Devour Corporation by selling in-the-money calls (options that rise in value as the shares of E&D rise) and using the proceeds to buy out-of-the-money puts (options that rise in value as the shares of E&D decline).

If E&D rises, then the owner surrenders the shares at a fixed price to the buyer of the call options. This means the potential gain above the strike price (the share price the call was sold for) is lost because that potential gain is what was traded away for cash.

If the shares of E&D remain high, then the out-of-the-money puts expire worthless. That looks like a "waste of money," just as health insurance looks like a waste of money if you remain healthy. But if E&D turns out to have invested heavily in Greek bonds, for example, and the share price plummets by 50%, then the put options explode in value and the 50% loss is offset by this rise in the value of the put options.

There is a value premium on in-the-money calls, i.e. they fetch a high price, as they are already worth something plus their time value (options have a time-decay feature, i.e. they expire on the third Friday of the month). Out-of-the-money options are cheaper because they have no value other than time. So the owner of E&D shares might sell 10 call options for $4 each (each contract covers 100 shares) and buy 40 out-of-the-money puts for 40 cents each.
Every hedge has a cost, either in cash or in potential gain that is being traded away for the insurance value of the hedge. You get what you pay for.

The reason for this long-winded explanation is that I expect the rest of 2012 to be highly volatile and risky. There are simply too many divergences and stresses in the system for complacency to be rewarded much longer. Boiled down to its essence, the situation we face is the global financial system is coming under increasing pressure as the global economy slides into a "hard landing." The central banks and states are masking this rising instability with politically expedient measures that all carry the risk of triggering unpredictable unintended consequences.
Surface stability is masking rising instability. That is an environment where hedging increasingly delineates those who will suffer catastrophic losses from those whose losses are fixed at modest levels via hedging.

This is probably the most valuable entry I have ever shared with readers, and it is entirely free. Being free, it is easily discounted. I would reckon its minimum value to anyone who "groks" its significance at $10,000. I don't expect anyone to send me $10,000 (though that would certainly be appreciated), but hopefully that number will make you re-think the hedges you have in place and consider adding some new ones.

For those who would like to know a bit more, there are plenty of resources on the web, and I cover hedges and relative value in my book An Unconventional Guide to Investing in Troubled Times (print edition) also available in Kindle ebook format.

I would like to thank Harun I. for his steadfast mentoring of my understanding of risk, hedging and relative value. Since I am thick-headed, it has taken me many years to truly grasp the consequences of these basic concepts. 

Thank you, Craig H. ($50), for your astonishingly generous contribution to this site -- I am greatly honored by your support and readership.Thank you, Gregory W. ($5/mo), for your immensely generous subscription to this site -- I am greatly honored by your support and readership.

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