Why holding cash is not an effective hedging strategy
December 23, 2019
When individual investors face uncertain future events, one common reaction is to start to hold greater amounts of cash. This is seen as a hedge against future uncertainty. An investor might sell gains, pay taxes and keep the residual in order to build cash reserves and build up a sense of security. Not only does this have immediate drawbacks like potential tax consequences, but over longer periods of time cash balances act as a drag on investment returns. Cash may feel safe, but the emotional benefit of holding cash comes at a high cost.
The cost of cash.
Consider the important concept of the time value of money. Simply put, cash in your hand today is worth more than the same amount of cash in the future. This is due to inflation and the opportunity cost of not being invested. If we assume inflation is low, at two percent, then $500,000 held in cash depreciates by $10,000 each year. And if we assume lost potential annual returns are equal to the rough average return for the S&P 500, eight percent; then $500,000 held in cash would fail to earn $40,000 in investment returns during year one. That $40,000, if reinvested, could earn an additional $3,200 the following year. And, given the assumptions we’ve outlined, over a five year period, the opportunity cost of sitting on the sidelines is over $234,000. To calculate your own opportunity cost, you can use this free compound interest calculator.
When and how to raise cash: There is a time and a place for holding cash, but cash is not a significant part of a sound long-term investment strategy. Loss limits are built into our equity investment strategy, so cash is raised if and when the loss on an individual position falls below a pre-determined level. Ideally, this creates short term losses which can be offset with long term gains to create net zero tax liability. This strategy means cash levels will naturally build in bad markets. We then reinvest the cash according to our investment principles. What we’ve just outlined amounts to cash being used strategically to mitigate the downside, especially during prolonged bear markets, and to minimize tax liability— we do not use cash as a hedge.
An alternative hedging strategy for sophisticated investors.
To hedge against the uncertain outcome of future events, it may be more efficient and beneficial to consider an option collar instead. When executed correctly, an option collar (a long put and short call contract) can provide downside protection over a stated period with little to no economic cost and sometimes even providing investors with a small net credit. For a primer on options, we like Investopedia’s guide.
Consider the following example, if an investor owned 500 shares of a stock currently priced at $62, they could hedge against the downside in the following way: If the investor were to sell calls on the position for a credit of $1,250 and buy puts for a debit of ($1,000), he or she would net a credit of $250. In this example we are selling a call, so we have sold another investor the right to buy stock away from us at $70. We are also buying a put, which means if the stock falls to $50 we can sell at that limit. This is how we constrain both the upside and downside in a narrow band, hedging against uncertainty and effectively making it less risky to hold the underlying stock. In our example, in addition to providing protection the option collar generates a small net credit of $250.
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When to hedge with an option collar: During the last several weeks, the most frequently asked-about risk event on investors’ minds has been the 2020 presidential election. The February primaries and the November election are two big potential spoiler events for equities and possibly worthy events to hedge.
While the emergence of a more progressive Democrat nominee this spring could result in a larger uncertainty discount on the forward market multiple, such an event is unlikely to create immediate downside risk for the SPX. We expect an uncertainty discount regardless of the nominees involved, but the discount will be applied more gradually in the event of a more centrist Democrat nominee. So gradual, that the discount may be unrecognizable in real-time but uncomfortable enough over time for some investors to perceive increased risk ahead.
The outcome of the November election may be a reason to hold more cash, but it’s important to understand that investors are presently only faced with the uncertainty of an outcome. And if you’re worried about the actual election results adversely impacting your investment portfolio holding cash isn’t the only way to hedge. You could also consider suitable no cost hedging strategies.
At Jackson Square Capital, we have the ability to protect appreciated positions using options collars and also work with clients to determine when to use options strategies as a hedge ahead of binary events like those mentioned above.
If you’re interested in learning more, please reach out to schedule a convenient time for a free consultation.