“Why it’s good to have a hedge even if you don’t have a garden”

Why so many investors still get it wrong

We all know that the stock market is a truly weird and wonderful arena, full of surprises, unexpected turns and dare I say it, heart-stopping moments. It’s where dreams are made and shattered in equal measure. 

It’s where a winner becomes one only at the cost of a loser. It’s where wealth is neither generated nor lost, but instead transferred from one person to another, like energy in what we now commonly refer to as ‘the zero-sum game’*.

However, despite these odd characteristics do you know what I think is the weirdest thing about the stock market? 

It’s the fact that despite however much effort an investor may put into his or her analysis before placing a trade, in the end it really is nothing more than a very simple binary bet – buy or sell – win or lose. In other words, the market either goes up or down and by doing so seals your fate. You can do all of the research in the world, and even then it usually comes down to the flip of a coin.

As the director of an FCA regulated stock broking firm, perhaps I should be telling you a different narrative given that I am recognised in the market as an ‘expert’. Maybe I should wow you with stories about how I’m able to pick shares with pin-point accuracy at their lowest price and then later sell them at their peak through complex trading algorithms. 

As nice as that story sounds, unfortunately I have a conscience and I like to sleep easy at night which is why I shan’t tell such fibs. 

That’s not to say that my experience and knowledge does not add considerable value – of course it does because if it didn’t my clients wouldn’t use me and I’d be at home watching another repeat of ‘Dragons Den’. It’s just that the value that I and other financial ‘experts’ like me may add, is probably not in the way that you might think. 

The reality is that trying to pick bottoms is not only a dirty habit that we are taught as children not to do, but it also happens to be a total waste of time. I should know – I spent the first five years of my trading career doing exactly that at great personal expense.

And as somebody who has been in love with mathematics for his entire life I often look at numbers for direction – because as we all know the numbers don’t lie. The statistics prove that many of these so-called ‘financial experts’ get it wrong time and time again when it comes to predicting the direction of the market, and particularly when trying to pick ‘tops and bottoms’ of individual shares. 

For example, did you know that before the financial crash of 2007-8 one report showed that as few as 6 respected analysts (out of 100) accurately predicted that there would be a crash. Now that’s a number you may wish to quote when you next speak to your financial advisor when they tell you how brilliant they are.

For example, in 2007 the American insurance giant AIG said the following “It is hard for us, without being flippant, to even see a scenario within any kind of realm of reason that would see us losing one dollar in any of these Credit Default Swap transactions.” 

Just a few months later Credit Default Swaps (CDS) were instrumental in the 2007-8 collapse creating the worst stock market crash since the Great Depression of the 1930’s. Later that year AIG collapsed, suspended its dividend, and took a bailout from the US Government worth over $85 billion!

Or maybe we should listen to Fannie Mae? In 2004 this behemoth mortgage and financing company gave this incredulous statement “These subprime assets are so riskless that their capital for holding them should be under 2%” – 4 years later Fannie Mae went bust and nearly took the rest of the world down with it.

So you see the truth is that to accurately predict market direction really isn’t easy and predicting the direction of individual shares is probably just as difficult.

After all, knowing when it may be a good time to buy or sell a share is very difficult in a world where prices are so volatile due to derivative and geared trading. It’s even harder when you consider that main market shares are also dependent on factors that are impossible to predict such as changes in interest rates, currency movements, regulatory changes, macroeconomic data, Government policies, taxation, international politics, wars, to name but a few. If you can get through all of that unscathed you then have to make sure that your analysis on the company is accurate(!)

So then why do the professionals still consistently do better the private investors? 

Well, I can only speak for myself but I know that for me it really comes down to having better knowledge and how that translates into better STRATEGIES. After all I’m no more intelligent or naturally blessed than the next person – and so if we assume that over the course of a lifetime ‘luck’ will even itself out (which I believe that it will), the difference between a good investor and a bad one can really only boil down to a difference in knowledge and experience between the two. 

This doesn’t mean that I would regard my individual stock selection as poor, and yes, I have managed to pick a lot of good winners along the way (I also have my fair share of losers too). The fact that I spend at least 8 hours in front of a screen every day should also give me an edge over most investors. However, where I feel that experts should really excel is where they are able to utilise the tools and knowledge that only they have, which results in better strategic planning across the portfolio. 

The Numbers Don’t Lie

Think about it like this. 

A 5% improvement on a £500,000 portfolio will give you an improved return on your portfolio of £25,000. Now compare that to a 5% improvement on an individual stock pick valued at £10,000 – that gives an improvement in return of just £500. 

Clearly if you get your strategy correct for your overall portfolio, that’s going to be far more beneficial to you than picking the occasional lucky winner. Of course, if you can do both then even better but if you had to choose where to focus your energy and efforts, it really should be on the former.

So, my advice is this – I say forget about spending gruelling hours analysing balance sheets or excruciating over financial projections that never seem to come true. Instead think about the overall strategy for your portfolio rather than focussing on individual stock selection. You can’t predict let alone control the direction of the market, so stop trying to. 

In other words, ladies and gentlemen, you will be glad to hear that the holy grail of investments, is actually far more simple and attainable than what you have previously been led to believe. 

And I’m going to prove to you exactly why this is the case and the steps that you can take to implement this new concept that may well completely revolutionise the way you manage your investments.

Stop following the herd

The first and most important thing in this process and which I encourage you to do right now if you wish to implement this new concept, is to stop whatever you are doing and step away from the market place. Disentangle yourself from the mayhem and stay well clear of the herd of investors (we all know what happens when you follow sheep towards the edge of the proverbial cliff). 

And yes, dare I say it, think differently – don’t continue to do something just because you have done so for years, or just because everybody else is doing it – it’s time to think outside of the box and by doing so you will naturally evolve into a contrarian investor. Whilst hated by most for their revolutionary and brave way of thinking, contrarians historically have proven themselves to be more successful than the ‘average’ investor (that’s why nobody likes them).

Of course, your average investor will counter this argument by saying there is ‘safety in numbers’, and admittedly this statement would be true albeit for a missing word – perceived (safety). The word ‘perceived’ followed by any word basically means that it’s somebody’s opinion, never guaranteed and therefore quite frankly of no interest to me. 

Worse still, when it comes to the case of the stock market, ‘perceived safety’ usually means the exact opposite because the stock market moves (in the long term at least) on anything but perception. 

The truth is that blindly following others under the flawed principle that “if they are doing it, then we should do it”, is invariably a recipe for disaster in most cases.

And so why is that? Well, it’s because the direction in which the majority of investors choose to go is usually not where your ship should be sailing. And the reason for that is very simple – when it comes to investments, the majority of investors are wrong and only the minority are right. 

And when the majority are right it’s only ever when the market is going up – think about it like this –  how many people do you know that consistently make money in a falling market? …Exactly.

Statistically we also know that each market will tend to have a small number of professional investors (investment banks, fund managers etc.) that can usually move and therefore control the market to their advantage. This isn’t as bad or as prevalent as it once used to be, primarily because of a tightening in regulations across both sides of the Atlantic pond, but don’t be fooled in thinking that it doesn’t still go on. 

Five years ago nobody knew about the LIBOR scandal – who knows what is going on today that we will only find out about in five years’ time? Unfortunately, cohesion and collusion by the big players is still alive and well.

So what ultimately happens is that as individual investors we follow a path which inevitably leads to a place where the experts and large investment houses continue to take the cash spoils from the unsuspecting retail investor market i.e. the average man and woman on the street. 

During the 2007-8 collapse, Goldman Sachs made tens of billions of dollars through a number of unscrupulous trades and strategies. And they were not alone. This sort of thing goes on all of the time (until they get caught). 

Wealth is therefore, in my humble opinion, being systematically and steadily transferred from the majority to the minority – from the rich to the poor if you will (not dissimilar to what we see in much of our society today unfortunately). Of course not all the firms are the same and it’s important to state that we mustn’t taint every large financial organisation with the same brush, but there is a reason why banking is the most hated profession in the world.

Before you ask, no I’m not a socialist and I’m not trying to make a political point here even though having read back this paragraph it may appear that I am. 

The point that I am trying to make is that the playing field is not unfair but it is definitely uneven. And the reason it is uneven is because some of the players on the pitch know a hell of a lot more than the others and so they’re obviously more likely to win the game.

By the way (just in case you’re wondering), the reason it’s not unfair is because nobody has a monopoly over knowledge. You just need to educate and arm yourself with the information that is available and you will soon even things up. Those who choose not to really have only themselves to blame. Either they don’t spend enough time learning or they will pass on that responsibility to somebody else and then fail to follow it up adequately. 

Remember that nobody is going to be more concerned about your investments than you.

I shan’t elaborate on this point but with over 20 years of trading experience and having worked for some very large institutions, I can tell you that I have personally witnessed this for myself many, many times. However, I am also sensitive to the fact that it is a highly controversial subject matter and is an entire (heated) debate in itself. More of that perhaps in the future, if anybody is interested.

Anyway, I digress – so let’s get back to the original point – the fact is that making money really isn’t primarily because of better stock selection but rather due to an improved overall strategy that comes from a greater knowledge of the market place, including how to take advantage of the investment tools at our disposal. That’s how the professionals do it – they see the bigger picture and ignore the intricate detail to the private investors.

So that means we need to adopt a new outlook on our investments, beginning of course by establishing a clear and open mind. Once we are willing to have an open mind and accept that there may just be a better way of doing things, then we can begin to focus on how we actually get an above market-return on our investments. 

How to make a return on your investment

Making a return on an investment involves two distinct parts: 

1) income and 2) capital growth. That’s it. 

Therefore, if you want to be successful in investing you need to have at least one of these two wrapped up and fully understood – if you can get both wrapped up, then so much the better. 

In the case of the stock market income is received via company dividends and the capital growth (an appreciation in the value of the underlying asset) is simply the profit made when you sell the share.

Similarly, if we look at property as the asset class rather than equities, the income equates to the rental income you receive and the capital growth is simply the increase in the value of the property when you come to sell. Simple, right?

So why do I share something so obvious with you? Well, it’s because if this is how you view your investments then you are like 95% of the rest of the investment community and you know what that means. Yes, that’s right. If you are in the 95% camp, then we have a problem (remember what we discussed earlier about being contrarian).

You see, your thought process is completely normal but as you now know, following the majority of investors who are indeed ‘normal’ is not where you want to be. You want to be different and take advantage of information and opportunities that others either don’t know or don’t really understand.

Now, as to income and capital growth I wouldn’t want you to think that these are not important – in fact these are absolutely essential factors to ‘portfolio growth’ but the point is that there is something far more important than portfolio growth – and that is ‘Portfolio Preservation’. 

I genuinely believe that if you can master the art of ‘portfolio preservation’ you will truly regain full control over your investments in a way that you have never done before. So now you just need to learn how to do it and I’m going to show you how.

Portfolio Preservation 

It’s more far more important not to lose money than to make money and that is a lesson which is unfortunately either not fully understood or just ignored by most. Portfolio preservation (sometimes known as ‘capital preservation’) is where 95% of the investing public unfortunately fall down.

In fact, I would argue that preserving your initial investment base is so critical that it’s probably more important than both income and capital growth added together. 

Think about it for a second. 

Numerical Illustration* 

If you have an investment portfolio of let’s say £100,000 with a goal of making 10% total return in a year (4% dividend and 6% capital growth), and assuming that you manage to achieve this for 3 consecutive years, the numbers will look something like this. 

Now let’s assume that in the 4th year the stock market crashes and falls by 30%. This means that your £133,100 portfolio falls to just £93,170.

So, after four years of investment (and all of the time and effort that you have spent managing those investments), your portfolio is actually down by 6.8% from when you started.

And if we assume that inflation averaged say 2% per annum over that 4-year period this would mean that the portfolio would be considerably lower in real terms – maybe around 13% less* than what you started off with, and even more if you take into account the impact of compounding.

This means that your portfolio will need to go up by 13% to get back to the original £100,000. If the market falls again the following year, then you’re in real trouble and you could be stuck in ‘negative equity’ for years to come.

So, in summary we can see that after 5 or more years of blood, sweat and tears trying to build your portfolio you are now back to square one, and all because there was no strategy or planning for portfolio preservation.  

Now, obviously this is a very simple illustration based on certain assumptions but nonetheless it does hopefully show that in order to be truly successful in the long term you need to find a way to mitigate your downside when the market falls, not just make money in the good times. Making money in a bull market is child’s play and something that I’m sure my two daughters (aged 5 and 7) could do in between fighting over their toys.

Remember if you don’t protect your initial investment, then any future capital or income that you may derive will be compromised anyway. You could use the analogy of a house and compare to that your portfolio.

If you have home insurance why wouldn’t you have insurance on your portfolio?

Like building a house the foundation is where the core strength of the house is and that’s exactly the same for any investment portfolio. Get the wrong builders in to construct that foundation (or maybe you construct it yourself but do it badly), then at some point your house is destined to collapse – you just won’t know it until the storm comes by which time of course it’s too late.

After you have built the house the next step is to insure it and that’s the equivalent of hedging your portfolio. It may not absolutely necessary especially if you believe that there’s no storm on the horizon, which is why some people just take the gamble and not buy any insurance at all. However, there is a well-known scientific law called “Sod’s law” which has been proven that at the precise moment that you choose to cancel your house insurance a storm is guaranteed to come and destroy your home. 

Of course hedging is not quite like taking out insurance on your car or your house but for the extent of this report you can broadly see it that way. The fact is that there are many ways of hedging i.e. reducing risk, and there are some strategies which are often regarded as tools similar to insurance.

In reality of course it’s not that people want to gamble by not taking out insurance on their portfolios. Unlike with their homes (everybody insures their homes), they just don’t know that this type of ‘insurance’ also exists for their portfolios.

As to the fixtures and fittings and what goes inside the house we can completely ignore those items, because without a good foundation and suitable insurance then that’s all pretty irrelevant anyway. In the same way that your choice of individual shares is also irrelevant if the overall portfolio is not structured poorly and there is no hedging in place to protect it.

The reason that I know this subject so well is because I have spent many years of my life reviewing and advising on portfolios not just for my own clients but also for others. I can tell you that in the vast majority of those cases, those individuals either have bad foundations or no insurance in place at all. And in a large number of those cases they don’t have either. 

The irony here is that most investors don’t want to gamble and yet they are doing exactly that without knowing it.

In my own personal situation, most of my clients are of a certain age where ‘not losing money’ is their number one priority. Their second priority tends to be maximising income and their last priority is actually making money (capital growth). And yet their portfolios if you look at them objectively generally paint an entirely different picture. 

This can only be down to a lack of knowledge which is of course not their fault but just a harsh reality of life. So I believe that what we are seeing more and more is a huge disconnect between what most investors really want and what they are actually ending up with.

It’s also worth remembering that if you don’t protect the downside then you really just end up with an index-rate tracker because your portfolio will simply go up and down with the market.  Of course, there’s nothing wrong with that if that’s what you are happy with, because in the long term the market tends to always go up (not dissimilar to property in fact). 

For example, in 2016 the FTSE100 index went up by a very healthy 19%. However the point is that if you are happy with that sort of performance, then you should probably sell all of your individual shares and funds and just buy a tracker because it will be much easier, cheaper and give you less headache.

But just for a moment, think if it was actually possible to keep the performance of the good years and somehow delete the performance of the bad years from your portfolio. How much better would your overall performance be? It sounds like a fairy tale but that is exactly what is possible if you know how.

In fact, many people have and still do make a very healthy living from whenever the stock market crashes. However, that’s not what I’m suggesting here as this does involve increased risk but once again it does illustrate the possibilities and the tools out there in the marketplace to capitalise from both rising and falling markets.

It’s not necessarily difficult to understand but like anything in life if you want to do it properly then you will need to invest some time and effort to learn. Once you understand it however you will wish that you did it years ago. After all, if you could find a way to reduce your ‘bad years’ even by 50% then that’s a life changing event for you and your portfolio.

There are also two interesting takeaways from this that are worth noting which makes hedging even more important to consider:

1. The market tends to fall much faster than it goes up – just look at any chart of a market crash in the past 30 years and you will see what I mean. There are specific reasons for this which I can explain if you are interested (feel free to email me at rsingh@londonstonesecurities.co.uk)
2. It’s much harder for you to recover a loss than it is to make a profit (any share portfolio that falls by 50% needs to increase by 100% to recover the same loss). That’s just plain maths.

That’s why it’s so critical to now re-focus your energy on hedging strategies and less time on how you are going to make a return. After all, in a rising market you would have to do something drastically wrong not to make a profit. Sure, if you want to make maybe 15% rather than 10% then you may have to spend more time analysing and researching but statistically you would be much better off keeping the original 10% and spending that extra time saved into thinking of ways to protect your portfolio from the next crash.

After all we all know that the question is not if but when the next stock market crash is coming. That’s why the most important question that you need to ask yourself now is how are you going to prepare for it.

Plan for the next Stock Market Crash 

Preparing for the next market crash is important because we all know that the stock market works in cycles and therefore we understand that the market at some point has to fall. That’s a fact. We also know that along the way the market will experience ‘market corrections’ which you could call mini-crashes. 

In other words, the market will never move up in a straight line and is subject to dips along the way, some dips being much larger than others. So if you become really good you could even develop a credible strategy to help you with both the corrections and the crashes.

In the same way that property rises in the long term so too does the stock market. That’s why the most common approach to investments is a ‘buy and hold’ approach which I would tend to agree with. You will often hear spoken the words ‘it’s not the timing of the market’ that’s important but rather the ‘time IN the market’. I’m not sure if I agree because I actually I think that they are both as important as each other.

It’s also certainly true that it doesn’t matter if you have a buy and hold approach because if you don’t have a ‘plan B’ in place to protect against the next market fall, then you’re always “moving two steps forward, one step back” (note that overall you are still moving forward but probably at half the pace that you could be).

And as explained this is where the professionals hold an edge, and a significant one at that.

The question then must be, “If we all know that the market will at some point crash why is it that only the professionals are doing something about it and not the retail investor market?”. 

It can only be because retail investors either believe that it’s not possible to hedge (protect) against a market fall, or they believe that it’s beyond their understanding.

In fact, neither statements are true. I’m glad to tell you that there are many ways in which you can hedge your portfolio and they are all incredibly easy to do (unless you have a particularly difficult or odd-shaped portfolio). 

In some cases, and as previously mentioned, you could even view hedging policies as types of insurance policies. Just in the way that you insure all of the things that are valuable to you e.g. your house, your car, your life etc. it would surely also make sense to insure your life savings and investments, the things that you have spent all of your life working hard to build.

That’s why it’s always been odd to me why investors wouldn’t insure their portfolios. However I recognise that in the vast majority of case it’s quite simply that most retail investors just don’t know what to do and that of course is not their fault. If you have never been taught how you are expected to know?

And like anything in life (other than perhaps advanced astrophysics) it’s easy once you know how.

In fact, at London Stone we have identified 10 different ways to reduce the risk of your portfolio from very simple things like selling and going into a cash (yes that is a crude but very effective method to protect your portfolio from a crash) to more tailor-made strategies involving derivatives and options.

Remember, the returns on your efforts are subject to diminishing returns and so trying to squeeze another 2% out of one of your shares is time-consuming, inefficient and really not necessary. Instead of focussing on the smaller details (i.e. individual shares), it’s time to step back and look at the whole picture (your entire portfolio) and you will see a difference.

We have all either witnessed or experienced the horror story of the 2007/8 financial crisis, and whilst portfolios have now recovered to what they were before the crash, for most investors it took on average more than 5 years. Just imagine, for half of one decade, investors were playing catch up and earning no return on their capital. What a waste. 

The professionals on the other hand were able to benefit from the panic that ensued during this dark period and shorted the markets therefore making money on the way down. 

So if you want to really improve your portfolio in the long run and you are ready to be different to all of the investors around you, the advice is simple. Take ownership and control over your portfolio by giving it the protection that it deserves. 

By the way the timing of this report is also no coincidence. With global stock markets around the world trading close to all-time ever highs, including the UK and US, something is eventually going to have to give. After all the markets can’t just keeping going up indefinitely.

This means that either we will witness a break-out to the upside of even newer breath-taking highs or the bears will awaken from their hibernation and come into force as they always eventually do, driving equity prices down with a thump. Whether that thump turns out to be a modest correction or a severe crash is anybody’s guess, but one thing is for sure; this time round and provided that you take appropriate preventative action, there is no excuse for either you or your investments to ever suffer again.

If all of this sounds daunting and you’d like to know more but you just don’t know where to turn, don’t worry. I love teaching – in fact I probably love teaching (almost) as much as I love trading, which is why I have taught people how to trade or invest for most of my life (yes they are two different animals). 

So, you’ll be glad to know that I am now running a number of one-day educational workshops at my City offices completely free of charge. You will learn exactly how you can hedge your portfolio before the next crash, as well as much more about the equity markets and the basic rules of expert investment. 

That’s right – after 20 years I have decided that it’s probably time to follow the advice that I have always given to my children – “caring is sharing”. That’s because I genuinely believe that it’s time to even things up a little between the ‘experts’ and the average investor on the street. 

So I will be sharing with you a number of my own strategies that I have developed over the years which has helped me to be successful in what I do. It’s not the holy grail, and it’s not the only solution out there but it is my solution and it does work. That’s why I still use it today.

The truth is that investing really isn’t as hard as you might think. All you need is to understand the simple strategies that have been tried and tested over the years. Along the way there are of course many short-cuts, tricks and tips that you can benefit to use along the way which I will show you – this will save you time, money and a lot of ‘oh no’ moments in your investing. 

Having said that It’s probably not time to put a down-payment on that Lamborghini just yet but I do know that if you follow a system and remove the emotion out of your investments, you are far more likely to become a better investor and more successful at the end of it.

At this stage, I genuinely don’t know how many of these workshops I will run because as you know my full-time job is running my FCA regulated stock broking firm which means my priority is always to help my clients first and foremost. I’m sure you understand.

Happy Investing and good luck.

Ranjeet Singh

Chief Executive Officer

London Stone Group

ABOUT THIS ARTICLE 

*Please note that there are some points in this article that have been intentionally simplified. The objective of this article is to give the viewer a sensible overview of the key benefits of hedging, rather than to unnecessarily complicate the subject. 

As with all investments there are risks to consider and you should seek financial advice before taking any action. This article should not be construed as investment advice and represents the views solely of the author.