The world is riddled with uncertainty right now. A glance at news headlines shows that. Inflation has not been this high in decades. There are mounting geopolitical risks from the largest land war in Europe since WWII. There are still remnants of a global pandemic. All these crises have led to ballooning US debt during a time when interest rates are poised to rise.
Risks abound, and this has been reflected in the stock market, both globally and domestically, with recent drops from all-time highs. With risks coming from all sides, what is an investor to do? Like anything in life, investing comes with trade-offs. In this post, we will discuss some of the biggest risks to investing, and the trade-offs of hedging against them.
Often when investors refer to “risk,” they mean market risk — specifically, the risk of the stock market going down. We have experienced a lot of that over the past few weeks. A hedge to this risk is owning bonds or cash. Having high-quality bonds and especially cash in an investment portfolio reduces its volatility (how much the portfolio moves up and down, on average).
The trade-off for this gain in stability, however, is that you are potentially giving up long-term growth. There is a common investment concept of risk versus reward. What this means is that the more risk you are willing to take, the larger the potential return needs to be to compensate you for taking the risk.
The risk with investing in the stock market is that your investment can decrease in value. Historically, over the long term this has been temporary. However, past performance does not predict future results. High-quality bonds do not have this same risk, so they do not need to return as much. If your main concern is reducing total market volatility, you will need to allocate a portion of your investments to high-quality bonds or cash.
Inflation is a top concern on many people’s minds these days. We see it at the pump. We see it at the grocery store. The poor souls trying to buy a house right now see it in the real estate market. Inflation was muted for many years until suddenly it was not.
One of the worst investments in a high-inflation environment is bonds. A synonym for bonds is “fixed income” because in most cases bonds pay a fixed amount. This payment stays the same regardless of what inflation is. The obvious problem with this is that, over time, that fixed payment you receive does not purchase as many goods and services as it used to.
There are a few common hedges to inflation in standard investment portfolios:
TIPS (Treasury inflation-protected securities): As the name implies, these are special bonds, issued by the US government, that adjust for inflation. These bonds typically pay less than a traditional bond does in normal times because of the hedge for inflation (risk versus reward). However, if inflation strikes, these bonds adjust, increasing their fixed payment to account for higher inflation.
Commodities: Another common inflation hedge is investing in commodities (gold, oil, wheat, etc.). These goods tend to rise with inflation over the long term. However, even though stock market volatility can be bad, commodities can be much, much more volatile.
Stocks: Historically, stocks have been one of the best stalwarts against inflation. Since companies adjust their prices to maintain their profit margins if inflation increases, stocks tend to adjust to inflation over the long term even if in the short term they remain volatile. The trade-off is some volatility for historical inflation protection.
There is much political uncertainty in the world right now. Despite all the troubles we may have here in the US, the current issues in Europe make many of ours look quite small.
A way to avoid some of this geopolitical risk, at least financially, is to not invest in international investments (stocks or bonds) and just invest domestically. Since much of the global economy is interconnected, you cannot completely protect yourself this way, but it is more of a hedge than holding these foreign investments.
The big trade-off to this is that the US stock market is only approximately one-half of the entire global market. By excluding foreign investments, you are effectively cutting off half of the possible options available to you.
Also, domestic and international outperformance tends to move in cycles. The US stock market has been outperforming international stocks for quite some time, one of the longest stretches on record. However, when the tables turn, complete divestment of international investments will mean you will not be participating in this growth.
Investments in the US are not immune to risks. We have our own troubles to deal with, and one that always seems to crop up during times of turmoil is our debt. What will happen to the US if we cannot pay our obligations? Will the US dollar collapse?
Of course, a way to hedge against this is to invest internationally. If something happens to the US markets, at least you will have investments in other countries. Another common hedge is investing in gold since the theory is that gold has never been worthless.
A newer option that has emerged is investing in cryptocurrencies like Bitcoin. These decentralized currencies are not tethered to any government, so if the US dollar fails or is no longer dominant, you may still have access to a medium of exchange.
Of course, all these hedges are fraught with their own risks. Like investing only domestically, investing only internationally cuts you off from about half of your investments.
Gold is not a company. It does not have profits or create cash flow. It is also expensive to ship, hold, and maintain.
Lastly, crypto is relatively new and unproven. The most common cryptocurrency, Bitcoin, can be difficult or expensive to purchase and keep secure, and is very volatile. Bitcoin has not proven to be a hedge against anything yet. Other cryptocurrencies are more recent than Bitcoin and much more volatile.
Diversification Is the Best Option We Have
Do you see the circular conundrum we face? To hedge against one risk means being exposed to another. To prevent market risk you need bonds, but to hedge against inflation you need stocks. To protect against geopolitical risks, you should invest domestically, but to hedge against our own troubles, you need international stocks.
The only practical way to hedge against many possible risks simultaneously is to invest in a well-diversified portfolio that invests in many different things. It is the closest thing in investing to a “free lunch.” Since you are spreading your investments around, the trade-off is that you are never going to hit a home run — but you are also staving off financial ruin if your “bet” does not pan out as expected.
Research has shown that diversifying your investments in a prudent portfolio decreases volatility while increasing expected returns. This is the only practical way to protect your investments from total financial catastrophe while also maintaining growth for the long term. The exact makeup of a properly diversified portfolio will vary, but the advice that you should have one remains the same.
There are always risks to investing, but these risks are heightened when geopolitical turmoil strikes. There are many different kinds of risks, a few of which we reviewed in this post. The best way to hedge against one risk may leave you exposed to others. The best way to protect against this, based on research, is to invest in a diversified portfolio in which certain investments target specific risks.
If you need help with your overall investment plan, please reach out to our team.
Nick Prigitano, CFP® is an advisor at Milestone Financial Planning, LLC, a fee-only financial planning firm in Bedford NH. Milestone works with clients on a long-term, ongoing basis. Our fees are based on the assets that we manage and may include an annual financial planning subscription fee. Clients receive financial planning, tax planning, retirement planning, and investment management services, and have unlimited access to our advisors. We receive no commissions or referral fees. We put our clients’ interests first. If you need assistance with your investments or financial planning, please reach out to one of our fee-only advisor.