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.
_____


"(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

_____

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.

_____

Year of the Hot Rabbit

Chinese real estate - hot as ever. But when will it fall?

Last week, the Chinese government implemented yet another measure to reign in the uncontrollable speculation that is gripping the Chinese real estate market.

Already implemented this year were new property sales taxes in Shanghai, and nationwide minimum down payments (for second properties) of 50-60%. This is on top of the Central Bank's three interest rates hikes since October. Now, as of this week, there are new rules for ownership in cities all over the country. In Beijing, for example, only residents are allowed to buy real estate (as proven by 5 years of tax returns and a residence card), and are limited to only one investment property.

It seems that due to strong new beliefs in capitalism, mixed with ancient beliefs about luck and prosperity, no one is getting the hint. Home prices are expected to increase another 6.4% for this year, despite public complaints about soaring costs.

It is impossible to say for how much longer this nonsense will continue. But one thing is certain - the longer it lasts, the more devastating the fall will be. My crystal ball, though hazy, sees the potential for riots.

____


"Speculation is only a word covering the making of money out of the manipulation of prices, instead of supplying goods and services."

Henry Ford

____

Lessons from Aristocrats - Housing

An elderly client visited my office recently to inquire about the interest rate for a personal loan. The purpose of the loan, he said, was to purchase a new water heater to replace the one that had just broken in his home. The man’s home…a 2.5 million dollar Tudor-style mansion.

This incident reminded me of something that happened to me when I was a college student. I had answered an ad for a basement suite, and was surprised to find myself standing in front of a hundred-year-old residence complete with carved oak staircase, vaulted ceilings, a library, a study, and an observatory. The owner, who had fallen on hard times, had recently converted the damp basement into six rental suites with a shared kitchen, suitable only to college students who will accept this type of accommodation. I kept looking anyway.

Most aristocratic families have, in their history, a successful ancestor who builds a massive family residence to showcase the family’s success. Winston Churchill’s ancestor, the 1st Duke of Marlborough, for instance, built a massive residence named Blenheim Palace.

Subsequent generations develop businesses, pawn heirlooms, gamble, steal, and whatever else is necessary in order to maintain the family estate, some generations more successfully than others. At some point, the family gives up trying to maintain the entire building and moves into a single section, leaving the rest to decay.

Eventually, the family mansion is donated to charity or opened to the public as a tourist attraction, since poor people will pay money to see how rich people live. Sometimes this eventuality takes hundreds of years, and sometimes it occurs within the builder’s lifetime.

The Marlborough family has thus far kept their estate. Due to Winston Churchill’s book royalties, his family has preserved Blenheim palace intact. Before Winston became a famous author (and later politician), the survival of the family residence was in doubt.

In Canada, people have the peculiar habit of moving into larger and larger homes as they become more established, until finally, after the children leave the nest, they find themselves in a home with far more space than they need. In due course they retire, and spend six months of every year in the warm southern United States, living in a camping trailer and enjoying it because it’s “easy to maintain.”

For aristocratic wannabes (easily distinguished by the phrase, “I do a lot of entertaining at home”), remember the lesson you can learn from the mistakes of real aristocrats: buy a home that you can comfortably afford, with rooms that you will actually use. The idea of having 10 extra rooms will bring you much more pleasure that actually owning them.

_____


"Few rich men own their property; the property owns them."
Robert Ingersoll, speech, New York, 29 October 1896

_____