Four Classic Hedges

"Hedge your bets," say the wise.

In the beginning, "hedge funds" actually hedged, meaning that they would make money in both rising or falling markets. Nowadays, the "hedge" in "hedge fund" has lost all meaning. Hedge funds simply invest in risky investments and/or use leverage (borrowed money). Most hedge funds these days do not hedge at all.

So what does it mean, exactly? What is hedging?

Hedging, in simple terms, is a method for taking precautions against financial risk. The goal of hedging is not to make money; rather, it is to prevent losing money.

As an example, if you are worried about a stock market crash, you can buy put options against the stock market, which gain in value if the market drops. Of course, if the stock market goes up, the value of your put options goes down – and the outcome is neutral. If you are a baker and are worried about the rising cost of grain, you can buy wheat futures that gain in value if the price of grain increases. If the price of grain declines, you will lose money on your wheat futures, but also pay less for the wheat you need – again, a neutral outcome.

The financially sophisticated investor has almost unlimited choices for hedging. But, this article is not about these sophisticated hedging choices. It is about simple hedging for the layman.

Hedge #1, Insurance
Say, for example, that you are a married father of two. If you were to pass away, your spouse would be left with the mortgage payments, the costs of raising two children, etc. Therefore, the wise person buys life insurance. If you pass away, your income to the family is gone forever; however, the life insurance pays off the mortgage, with hopefully enough money left over to see the children through college. Thus, life insurance is your “hedge” against possible financial ruin caused by your premature death. Virtually everyone should have life insurance, disability insurance, home insurance, and home content insurance (the building and its contents are usually insured separately). The goal of insurance is not to have so much as to guard against any possible occurrence – it is to buy just enough to prevent extreme financial hardship.

Hedge #2, Gas and Oil
If you drive, consider buying stocks of a large oil company, or an energy mutual fund. As the price of oil (and gasoline) goes up, you can be compensated by an increase in the value of your oil company stock, and also an increase in the amount of dividends it pays you. If the price of oil goes down, your oil stock may decline in value, but so will the price you pay at the pump – this is classic hedging.

Hedge #3, Real Estate (for current non-owners)
If you rent, consider buying a real estate investment trust (REIT), a form of stock market real estate investment. If real estate values increase (along with your rent), the income provided by the REIT will also increase. If real estate values decline, your rent will likely not decline (unless you change buildings), but it won’t go up, either – a 3/4 hedge.

Hedge #4, Household Energy
Almost everyone pays for electricity and heating supplied by a utility company. Utility companies are not only some of the safest investments around, but they also pay regular dividends. The more money they make, the larger the dividends. Utilities can be bought through utility ETFs or utility mutual funds.

The first hedge (insurance) can save you from ruin and protect your family. The final three are long-term inflation killers. Together, and for a minimal outlay of cash, they protect you from both unforeseen circumstances and unexpected costs.
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"(Gold) gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head."

Warren Buffett

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Do not buy stocks, or take this or any other financial advice without doing your own analysis; including, but not limited to: reviewing business models, financial statements, management style and philosophy, recent developments, market macroeconomic analysis, and chart analysis. If you do not know how to do these things, you shouldn't be buying stocks in the first place. Seek the advice of professionals, as appropriate.

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The Retail Gold Rush

Gold bullion is at record highs, and is set to rocket still higher. At least, this is the official sentiment of The London Bullion Market Association. But with prices already at record highs, is this the time to buy gold or the time to sell it?



There are two reasons commonly given to buy gold now. The first is that gold is a store of value. That is, although inflation eats away at the value of currencies, gold has a value that cannot be taken away. The second reason is that uncertainty drives gold prices higher, and today’s markets are certainly uncertain.

Gold is indeed a store of value, a currency, a component of jewelry and electronics, and more. The problem is that gold – like other commodities - usually keeps up with inflation and the business cycle but does not exceed it. In the past 3 years, however, gold has exceeded inflation greatly. Fear and speculation are the drivers of gold prices now.

Earlier this year, we saw the advent of gold-to-go machines. These vending machines hold a quote for 10 minutes, then scan the market and recalculate so the customer is always getting an up to date (but marked up) price. In Europe, these machines can be found in airports, hotels, and even supermarkets. For me, the gold-to-go machine marked the entry of retail “stupid money” into the market - money that arrives too late and stays too long.

If gold vending machines weren’t enough, consider the rise of solid or yellow gold miniatures. A few years ago, gold miniatures were an exclusive novelty. These days, the windows of high-end Chinese jewelry stores are loaded with solid gold rabbits, dragons, boars, oxen, and popular cartoon characters. The miniatures are popular with Chinese, since they offer a way to store wealth for posterity while simultaneously flaunting it.

The final sign of the gold peak is the de-hedging process of the gold producers themselves. In order to reduce income fluctuations caused by changing gold prices, most gold producers partially hedge their gold using futures or options. For example, companies buy futures that go up in value when gold goes down, and that go down in value when gold goes up. By hedging with futures, companies will not benefit as much from rising prices, but they will also not get stung by falling prices (arguably more important for profitable companies).

This year, many major gold producers have greatly reduced or even stopped hedging in the expectation of forever-rising prices. Barrick Gold, AngloGold Ashanti, Gold Fields and other companies have reduced their gold hedging by millions of ounces.

So, is gold going to drop? Should you short it?

At this point, there is still widespread fear all over the world, and this is partially justified by a worldwide housing bubble and precarious economies. Shorting gold at this point is probably not justified. However, neither is jumping on the bandwagon.

Gold prices are high – really high. Both as an investment and as a novelty, gold is more popular now than it has been in a very long time. I would refrain from buying. If you already own gold, consider selling some.

If you believe the world's currencies are being debased and you need to protect yourself, buy producers of commodities that have uses beyond merely a store of value - such as oil, uranium, lithium, and copper.

Buying something at the peak of its popularity is not always a stupid financial move, but statistics are against you.

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"My dear girl, there are some things that just aren't done, such as drinking Dom Perignon '53 above the temperature of 38 degrees Fahrenheit."

Sean Connery as James Bond, GoldFinger, 1964

Gold, Finger

Nothing excites people like gold. It is malleable, shiny, never loses its luster, and looks great around a girl’s neck. It is the stuff of legend, where a new discovery can make a man rich overnight. Gold is now at record prices, and the airwaves are inundated with ads to buy gold, sell gold, and invest in gold. What do you get when you combine beauty, excitement, and instant riches? Why, a great opportunity to scam investors, of course.

The typical gold mining scam follows a theme with common elements. The first of these is a great story. Maybe the speculative property is an “overlooked” piece of land next to one owned by a large mining firm. Maybe the owner went bankrupt and had to sell it on the cheap, regardless of its true value. Maybe the story combines a bit of everything.

I attended a seminar of a TMX-venture listed company a couple of years ago that nicely illustrates the “story” portion of a gold venture. First, the meeting place itself. The conference room was supplied with boxes covered in gold foil (each of which, I was told, represented one metric tonne). On the tables were gold vases and gold foil chocolate bars on gold tablecloths. But aside from flair, this presentation had a great story.

As I soon learned in a video, an old prospector (we’ll call him “Yukon Bob”) had a gold mine. The mine was so successful that he made a living at it using only a pick, shovel, and some occasional dynamite. It was this dynamite that proved his undoing. Yukon Bob’s beloved mine collapsed upon him, killing him instantly. That was about a hundred years ago. The family kept the property, but did not mine it in memory of poor Yukon Bob. Our heroic CEO convinced the family to sell this accursed mine to him for a small sum, just to be rid of it. Great story.

After hearing the tale, I perhaps didn’t look as excited as I might. The CEO noticed this, and immediately sent over a honey trap. Sitting uncomfortably close for a room full of people, the lovely lady asked me what I do for a living. Upon saying, “banker,” I thought I could see drool form at the edges of her mouth.

The other part of their story, which is typical of gold-mining presentations, is the quality of management. Having nothing but a hunk of land and an office somewhere, the company will tell you how management is “well respected” in the industry, and has “100 years” of experience between them.

A truly really great opportunity (you will hear) is when the company has not yet gone public. They will hint that if you invest now, the eventual IPO will make you rich whether the company finds gold or not. Not mentioned is that in the meantime, the CEO and directors will pay themselves nice six-figure salaries using your money until, hopefully, the company goes public as planned. At the peak of the hype, the owners will sell most of their shares, leaving penny stocks that will eventually get bought out by still more promoters, at which point the company’s name will change. This is why venture companies often have press releases for names that read like a play-by-play of what is hot in the market; for example, “Super Wind Alternative Energy, formerly known as Capsule Biomedical, formerly known as BuyIntoIt.com, has changed its name to Gold Sierra Cortez Inc.”

Then there are companies that tell you the truth, but neglect to mention the downside risks. Take for instance, a company that made a great gold discovery in Peru. The core samples showed excellent potential. The mineralized area was close to the surface, in rock that was easy to mine. All great so far. What the promoters neglected to mention was that the property is commercially inaccessible except by helicopter, that local prospectors frequently get kidnapped and held for ransom, and, oh yes, the small matter of the thousands of land mines.

Of course, some companies actually do search for gold, and some even build mines and strike it rich: probabilities, however, are not on your side.

The “golden rules” (pun intended) of investing in venture mining companies are as follows: first, if you want to invest your money, choose companies that are either in the process of building a mine or where production has already started – this alone with weed out the 95% of discoveries that never pass the feasibility stage; this should be the start of your research, not the end. If you want to speculate, there are almost no rules save one: don’t commit a penny more than you don’t mind losing.

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“Oh, the only gold I know about is the kind you wear... you know, on the third finger of your left hand?” Miss Moneypenny to James Bond, Goldfinger, 1964