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The Best Hedge is Cash

Written By Briton Ryle

Posted December 23, 2014

It took just 16 days for the last stock market correction to play out… 16 days for the Dow to drop 1,275 points.

In dollar terms, that’s about $500 billion in investor losses. Ouch.

Any time there’s a decent market correction, the financial media pundits start cranking out articles about what you should have done to hedge your bets and protect your investments from losses.

Here are a few of the “suggestions” I’ve seen in recent days…

  • I’ve seen the experts tell individual investors they should buy inverse ETFs — which are designed to gain in value when certain assets go down in value. I’ve seen them recommend buying leveraged ETFs that use options and futures contracts to magnify the gains when stock prices fall.
  • I’ve seen the experts say you should buy a volatility ETF because volatility goes up when stocks prices fall.
  • I’ve even seen them suggest you should buy put options that will go up when stock prices fall.

Yeah, yeah. Hindsight is always 20/20…

Now, I want to be very clear about this: Each of these suggestions can be useful. After all, it is technically true that each of the strategies mentioned will produce profits if/when stock prices fall.

Still, there’s a big, fundamental flaw in these suggestions. And it’s the same flaw for each, too — a flaw that has a very good chance of saddling you with even more losses…

What if you’re wrong? What if your timing is off?

Time the Market? Good Luck…

The fact is, buying an asset as a hedge against losses to your investment portfolio depends almost entirely on market timing.

You have to buy the asset at the right time, and then you have to sell it at the right time as well. If you’re a little off, you may well lose money.

I’m sure you’ve heard people say timing the market is impossible.

Fidelity’s Peter Lynch said it best: “Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.”

The last few times the stock market sold off, it went down about 3% to 4%. What if you bought a bunch of put options when the market was down 3% because all the pundits said “this was the big one” and stocks were going to fall further?

You’d have lost a chunk of change…

Market timing is very difficult to get right. How many times over the last couple of years have the “experts” said stocks were due to sell off when they didn’t?

I monitor the financial markets every single day they are open, and I can count on one hand the number of times in a year I feel darn confident about what’s going to happen in the next day or two.

In addition to the perils of market timing, there’s one other major problem with buying some asset to hedge your investments against losses: the simple fact that you are buying something.

Any time you buy something, you could lose money. The value of whatever it is could go down, and you won’t get all your money back when you sell it.

And if you’re wrong with put options, you can easily lose 50% or more in a matter of days.

At least if you buy an inverse ETF, the price won’t change too much if you’re wrong. Maybe you’ll only lose 10% or 20%…

But since options are contracts, they expire within a certain time frame. Options steadily lose value as the date on which they expire approaches.

What’s more, options quickly lose value if stock prices move in the wrong direction.

I suppose if you’re a hedge fund manager, it might make sense to use put options as a hedge. But for the average individual investor, put options are a darn risky way to go. If prices stay the same or move in the wrong direction, you will lose money.

The only time you make money with options is when stock market prices move exactly as you expect them to. And how often does that happen?

A Better Way to Hedge

People who own dividend stocks don’t tend worry as much about stock market corrections. They make consistent income just for owning the stock.

If you’ve held a stock for 10 years and you’ve taken in 30% of the stock’s value in cash income, you’re probably not going to worry if the price of the stock falls 10%.

After all, you’re still going to collect that dividend no matter what the stock market does.

The dividend acts as a kind of natural hedge against stock market sell-offs.

Most individual investors don’t know you can get a sort of dividend from just about any stock you own, even if the stock doesn’t pay a regular dividend.

What’s more, this “ownership” dividend can be five or six times bigger than a regular dividend, and you can collect it many times over the course of a year so long as you own the stock.

All you have to do is agree to sell your stock at a higher price than you paid for it.

Let me share an example with you…

About six months ago, I recommended a biotech stock that was trading for $8.78 to a group of individual investors. Thousand-share lots cost $8,780.

Right away, I advised them to take an “ownership” dividend that amounted to $1,050 in cash. All they had to do was agree to sell those shares at $10. Again, that $1,050 was deposited right into their brokerage accounts, and they could spend it as they pleased.

A couple months later, they entered into another agreement to sell the shares at a higher price, and they were paid $600 in cash.

After that, they entered into yet another agreement to sell the shares at a higher price and received yet another cash payment, this time for $750.

So in six months, these investors have collected well over $2,000 in cash on an $8,780 investment. And they still own the shares of the biotech company, so they will keep on collecting these “ownership” dividends as long as they own the stock.

This hedging technique is one of the most powerful I’ve come across. And in many cases, you can just about name the amount of cash you want to take.

This cash-generating strategy is available to just about every investor on the planet, yet very few actually use it. And don’t worry about risk — this systematic approach to profits is deemed so safe by the SEC that you can use it in your IRA retirement account.

Respected research firm Value Line says this strategy is “ideal for retirement accounts such as IRAs, since [it] offer[s] income and protection.”

If you’d like to learn about how to use this strategy to take in regular cash and protect your investments against stock market declines, just click here.

Until next time,

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Briton Ryle

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