INTRO

We march closer towards volatility solutions.  We finished our New Vol series (see Part 1 here) where we bridged the gap between financial risk and the solution of building personal resilience.  We redefined volatility from a market decline to a systemic shock.  We then proposed an insurance approach to risk management where we, the investor, absorb the smaller risks of a market correction, and we insure the larger risks by accumulating wealth across other buckets of capital (financial, material, social, cultural, time, living, emotional, and knowledge).  This new hedge aims to provide enhanced protection and improved quality of life by recognizing that all buckets are important, not just the financial one.

We are still, and most always, exposed to a market correction.  And during these corrections and crashes we tend to see most assets move lower together.  Said another way, at the extremes, asset correlations rise.  And because we have moved our volatility hedge outside of our portfolio, we need to understand that we are still at risk.

WE NEED MORE COW BELL!

Volatility is a unique beast.  We can support the need to hedge through exposure to “long vol”, as we are reminded from a favorite Christopher Cole chart:

 

The above chart highlights the strong correlation between all asset classes and supports the need for hedges (long vol).  We think we are diversified by owning many different assets, but in periods of extreme market stress, the volatility monster destroys all.  Therefore, it is important to incorporate long volatility into your portfolio in some way, shape, or form.

New Vol exposed some of the challenges of traditional volatility strategies, and for this reason, we look for fresh ideas.  It is critical that we are either comfortable with these risks, or that we are doing everything we can to manage these risks.  This post will expand on our thought experiment to find specific outside-the-box ideas to incorporate hedges into our portfolios and also in our lives in general.  What else can we do to reduce the pain of a major market correction?

SYNTHETIC VOL

We’ve already checked a big box with our personal resilience solution, which has us more prepared for that “pencils down” moment.  The personal resilience strategy can act as a better real-world hedge, and here are a few more examples:

EMOTIONAL RESILIENCE: we should strive to have this bucket of emotional capital so full that 1. Nothing would surprise us.  2. We will not emotionally fold like a lawn chair.  And 3. We are physically, mentally, and emotionally strong enough to help ourselves and others in any time of need.

COMMUNITY CAPITAL: we are stronger in numbers.  Hiding in a bunker in the mountains may sound interesting, but it lacks the richness and rewards we seek in life.  Being around those you can trust, people you enjoy, and others who can help shape a regenerative future is paramount.

PRIMARY WEALTH & SUPPLIES: in “New Vol”, we made the case that it makes sense to invest in food, water, energy, shelter and supplies.  There exists a large spectrum of investments in this category, and your imagination is the only thing holding you back.

In addition to personal resilience, we can look at other strategies that may allow us to fight another day.

PORTFOLIO SOLUTIONS

Portfolio level risk is at the top of this list.  We discussed the risk factors of a 60/40 (stock/bond) portfolio compared to a multi-asset approach.  You can see in our previous posts here and here.  The punchline is that a multi-asset portfolio is lower risk.  Again, we are not favoring one versus the other, we are highlighting risks and potential solutions.  We’ve always believed that your best investment is education.  It’s important to know two things: what is our appetite for risk and is this aligned with our portfolio?

Another way to introduce a synthetic hedge is to buy more of the assets less exposed to a market meltdown.  The assets on the deflation and insurance side of our barbell approach are cash, precious metals, and primary wealth/supplies as mentioned above.  We are intentionally leaving bonds out of this category.  It all comes down to the correlation between stocks and bonds, and this is a lively debate.  Our simplistic view is that these two assets have risen together for 40-years through the last interest rate cycle of lower rates, and we do not want to bet on them NOT cycling together in this paradigm shift towards higher rates.

The third and final synthetic hedge we will highlight is the purest form of volatility: options.  We understand that options are not for everyone.  At the same time, we can say that options can be as complex or as simple as you want to make them.  We are not looking to reinvent the wheel and become a derivatives expert, but it is worth mentioning that options can be extremely valuable and helpful to shape our positions and portfolios in different ways.  Because our synthetic vol is implicit (indirect) market hedges, we can easily make a case for explicit exposure through options.

THE CLOSE

Mr. Market is a dangerous player.  We need to be aware of the risks in this game.  We have laid out potential solutions against an unknown future.  It starts with understanding the rules of engagement, why we are here, and where we hope to go.  We’ve spent a lot of time blending the market into our personal lives, as the markets appear to play an ever-expanding role in our world.  We will always favor education and the importance of a plan that includes protecting and supporting family and friends.

 

Disclaimer: The information contained in this article is for informational purposes only and should not be considered as investment advice. The information presented in this article should not be interpreted as a recommendation to buy, sell or hold any security or investment. Before making any investment decisions, it is important to do your own research and seek advice from a qualified professional. Investing in securities and other financial instruments carries a high level of risk and may not be suitable for all investors.