How can you hedge against your investment risk and protect your assets in an unsafe world?

The reality is, we live in a challenging investment climate. Stocks are expensive, hitting all-time highs on the stock market. Bonds are also, as interest rates remain very low. Because traditional bonds tend to have an inverse relationship with interest rates, when interest rates are low, as they are now, bonds are expensive. We’ve never seen an economic situation where both stocks and bonds are this expensive.

At the same time, we want to see strong growth potential in our investments. Just because stocks are expensive now doesn’t mean they won’t continue to rally. If we see tax reform from Washington this year or next, I wouldn’t be surprised to see our market continue to hit new highs. Now, I don’t know that for certain. Nobody can accurately predict what the markets are going to do. But I wouldn’t be surprised. Consider that stocks were expensive in 1997, yet they continued to hit new highs for another 3 years before falling.  

So, how do you achieve growth, but not put yourself in a position to take big losses? There are different ways to do this, many of which we’ve previously discussed, but one that’s not frequently discussed is using time as a hedge for the risk investing. Time can oftentimes be a very effective hedge.

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Individuals in their 20’s and 30’s can very naturally use time as a hedge, with 30 or more years to ride out market fluctuations, especially for their retirement accounts. But, if you’re looking to retire soon or are already retired and you will need to draw income from your investment, you don’t typically have time as a hedge. So, how can you build time into your planning as you get closer to or are in retirement?

You segment your money based upon when you’re going to need it. You should live on your safe assets for at least the next 5 years, meaning those assets have guarantees of principal, or else are very stable (with guarantees, you will need to evaluate who is backing those guarantees). Then, you buy time with risk assets. You don’t want to live off of the assets that are going up and down in value daily, monthly, or yearly, because, inevitably, they’re going to be down. And if you’re selling off your assets and spending that money when they are down, you’re compounding your losses. It’s okay to sell investments when they are down and then reinvest, but you don’t want to sell when they’re down and then spend the money as income.

One of the ways that you hedge the downside risk is by buying more time for those assets, knowing that you won’t need to depend on them for at least five, if not ten, years. You will still need other hedges in place to protect yourself from losses, but building time into your retirement plan is a critical component of protecting your assets in an unsafe world.