Now that the market has rebounded substantially off its lows, how do advisers know when to enter or exit the market? The short answer is that they can't know. Market timing is an ever-elusive game. Instead, advisers can look for strategies to keep their clients invested but with hedged positions that protect their portfolios if things go sour.
Being invested in the market while hedged lets investors participate in up markets and reduces their participation in the down ones. No market timing is needed.
(More: As volatility rises, United Capital gives advisers crash course in alts, options)
It's easy to grasp the concept of protection and avoiding losses by hedging. It's like buying insurance — no one likes having to use it, but you're glad that you have it when there's an accident. While hedging can be done in many ways, it provides the protection that investors are looking for when the market moves substantially against them.
But there's a second aspect of hedging that may surprise you. In addition to keeping its users from participating in the full decline of the stock market, it rewards them with the opportunity to buy more shares of the market while it's down. Strangely, the benefit of this opportunity increases the more the market drops. Think of it as buying the market at a discount with pre-discount capital.
We call this activity "reinvesting avoided losses." Oddly enough, there is a perverse incentive for the hedger to watch the market drop as far as it can before reinvesting the avoided losses.
Let's say the market drops 30% but your hedge portfolio only drops 10%. When your hedges expire, you're going to have 20% more money than if you had not hedged. That 20% can buy more shares while the market is at a discount from the drop.
The deeper the drop, the deeper the discount and the more shares you can own for the way back up. That's what we call the "hedger's opportunity."
Naturally, no one ever wants to use their insurance; it means something disastrous has happened. But having it lets you sleep at night knowing you've got some protection.
The same goes for being in a hedged strategy. December's multiple days of market declines brought feelings of 2008 back, along with renewed anxiety and fear. It reminded us how important hedging can be.
(More: ETF investors are rewriting the rules on hedging risk)
As advisers, we still must invest our client portfolios. Is a retest of the December bottoms in store for us in the short term? Tough to tell but hedging will give you the confidence to stay invested for additional market appreciation and avoid the full brunt if the market revisits its lows. Of course, if it gets really bad, there's always the hedger's opportunity to take advantage of.
(More: Advisers should make the most of volatility for clients)
Jay Pestrichelli is co-founder of ZEGA Financial.
