Revealing the Secret of the ‘Hedged’ Portfolio.
In 1966 an article in Fortune magazine described a man called Alfred W Jones as ‘one of the wonders of Wall Street’.
Jones had established a unique investing firm whose returns had beaten the best mutual funds of the day. Part of the wonder was that Jones didn’t have a conventional background in banking or finance.
He came to investing just before he turned 50, having originally trained as a sociologist and at one point making a living as a writer.
But the numbers didn’t lie. After starting out with USD$100,000, seventeen years later it’s estimated Jones was managing $70 million. Jones had taken on the stock market and made millions.
The article in 1966 ran with the headline, ‘The Jones Nobody Keeps Up With’.
All this might seem like an interesting history story, but one of Jones’s key ideas is still relevant for investors today.
It’s called ‘the hedge‘.
This was how one of the first hedge funds was born…
Jones used a combination of two techniques. He borrowed money to buy shares (‘leverage’) on top of his original capital, and used short selling. Short selling is a way to profit when shares fall.
The firm A.W Jones (it’s still going today) has this note on its website:
‘Each technique was considered risky and highly speculative, but when properly combined together would result in a conservative portfolio.’
Jones used short selling to limit his overall exposure to the direction of the stock market — to avoid what traders call market risk. He used the term ‘hedged’ to describe the risk exposure in his fund.
The way it worked was that Jones had positions in place that could profit if the market rose but others that could profit if the market fell.
The main point is Jones conceded that he could never reliably predict which way the stock market would go.
The way to work around this was to build his portfolio on the assumption that he had every chance of getting the market direction wrong as well as right. In the face of the uncertain future, Jones’ insight was to hedge that risk.
The idea of a ‘hedged fund’ took off and, according to Wikipedia, as of 2012 hedge funds globally account for over $2 trillion of funds under management. Today, the manager of one of the biggest hedge funds is Ray Dalio…
So when Dalio talks, people listen.
Dalio thinks you should structure your portfolio with a similar approach to the ‘father’ of hedge funds, Alfred W Jones. It doesn’t involve stock picking or short selling or using leverage, but working on the assumption that you can’t know the future.
Dalio recently gave a lengthy interview on the world economy. One point he emphasised was how often he’s been surprised by how events turned out over his forty year career in investing. He gave two examples.
The first was when Nixon broke the US dollar’s link to gold in 1971. When that happened, Dalio expected a major crisis. Instead, early on the US stock market rallied.
The second was a decade later, when American banks had made massive loans to Latin America. Dalio figured the Latin American countries wouldn’t be able to pay them back. A major default seemed like another emerging crisis.
He was right on one point. Mexico eventually defaulted on its loans in 1982. Regardless, that year was the beginning of a major bull market in stocks.
From experiences like these, Dalio says that the best and least risky option is to build your portfolio to survive and profit in the face of four basic scenarios: inflation or deflation, growth or contraction. You never really know which one is coming.
But how to do it?
Unlike AW Jones, he doesn’t think you should do it by going long and short in the stock market, but by buying a spread of different asset classes.
Pressed on how much exposure you want to have to gold versus shares and other asset classes, Dalio responded:
‘For the average investor, what I would encourage them to do is to understand there’s inflation and growth — it can go higher and lower — and to have four different portfolios essentially that make up your total portfolio that gets you balanced, because in every generation there is some period of time that will ruin — there is a ruinous asset class — and will destroy wealth.‘And you don’t know which one that’s going to be in your lifetime. So the best thing you can do is to have a portfolio that is immune, that is well-diversified, that is what we call an all-weather portfolio. That means that you don’t have a concentration in that asset class that’s going to annihilate you. And you don’t know which one it is…’
So, is this approach limited to wealthy hedge fund investors? No. The good news is you can replicate Dalio’s strategy to gain this type of exposure for your portfolio.
Dan Denning has had this figured out for his subscribers since the middle of last year when he told them about something called the Permanent Portfolio. It’s basically a working model of Dalio’s suggested blueprint,but with Dan’s own take on it.
And with interest rates falling, China slowing, and it becoming harder to make gains on the stock market, this strategy is shaping up to be more important than ever.
To find out how Dan suggests investors construct a ‘hedged’ portfolio,go here.
Callum Newman
Co-Editor, Scoops Lane
This article is contributed by Money Morning. Click Here to Subscribe to their free newsletter.
