Why Hedging Is an Important Investment Strategy

While depository financial organizations typically allow only cash or time deposit (certificate of deposit) investments, other investment firms (e.g., broker-dealers) focus on corporate stock and other securities. Self-directed IRA custodians, such as STRATA, allow IRA owners to purchase nearly any investment that the IRS permits. This lineup includes real estate, promissory notes, precious metals, closely held stock, and much more. These alternative investments are often attractive because of the potential for considerable growth. But another benefit—one that we don’t hear about as often—is the “hedge” that certain alternative investments can provide.

 

Correlation Is Key

Correlation is a statistical measurement of how assets move in relation to one another. For instance, a positive correlation would indicate the extent to which one stock (or stock class) increases in value in relation to other stocks or stock classes also gaining value. A negative correlation indicates that an investment decreases in value as another increases—or vice versa.

Correlation in Action

Consider times when the U.S. economy has experienced vigorous, healthy growth. Often, stock investments increase in value across the board, whether they are individual securities or indexed mutual funds. These stocks and funds have a positive correlation: when one stock or sector grows, others are growing, as well.

On the other hand, consider a faltering U.S. economy where stock values are plummeting. While stocks nosedive, other investments, such as gold bullion, may grow substantially. This would demonstrate a negative correlation.

One of the key tenets of modern portfolio theory is the concept of diversification—this means not putting all your eggs in one basket. Investors should consider their own risk tolerance and the relative risks and returns of the investments they choose, and they should diversify their investments. If a more volatile asset drops in value, the investor should consider counterbalancing this asset with an investment that has a negative correlation to the falling asset. This means that the other asset (or the “hedge”) may help offset the loss in value of the falling asset.

 

Other Factors to Consider

Correlation is not the only factor to consider when creating a balanced and diverse investment portfolio.  Historically, alternative investments often perform well despite market volatility but they have important differences that investors should consider:

  Stocks  Alternatives 
Liquidity  Publicly traded stocks are extremely liquid. Even mutual funds can be traded like regular stock through an exchange-traded fund (ETF). Over-the-counter stock (stock not traded on an exchange) or private placements may be much less liquid. Some alternatives (e.g., gold) may be liquidated easily; others (e.g., real estate) may be relatively illiquid.
Expenses Stock trading can be free or low fee in many cases. Many ETFs and mutual funds have modest expense ratios. The diversity of alternative investments produces a wide range of expenses. Some (e.g., gold) require a third-party storage expense. Real estate in an SDIRA requires ongoing maintenance by a third party. Other options may involve complex fee structures and performance-based fees.
Other Stocks may have different correlations between various sectors and geographic areas (e.g., global vs. local companies; micro-cap vs. large cap). Investors can create certain hedges with their choices, but certain options (e.g., uncovered calls) may be prohibited in SDIRAs. Alternatives may have positive or negative correlations with more traditional investments, so the opportunity to diversify is great. Some investments (e.g., real estate) may lack liquidity but may produce growth through both appreciation and rental income.

 

A Self-Directed IRA Can Be an Excellent Hedge Tool

It’s easy to forget that retirement savings may represent only a portion of a total investment portfolio. For some people, of course, their retirement savings are by far their largest asset. Whatever your scenario, you should consider your SDIRA investments in the context of your entire savings scheme. For example, if you have assets invested in liquid, federally insured, guaranteed-return time deposits elsewhere, it might make sense to invest some of your SDIRA assets in alternatives that are negatively correlated with your other investments and that entail different risk and return characteristics. See how other investors leverage their SDIRA in STRATA’s 2023 Self-Directed IRA Investor Survey Report

 

 

STRATA cannot make investment recommendations to you—we recommend seeking sound investment advice before making any decisions. However, our SDIRA experts are available to field your questions about IRA administration and operations. Once you decide on the best investment mix for you, don’t be bound by a narrow range of options that someone else chooses. Instead, use your SDIRA at STRATA to select the investments that work best for you. For questions, or if you’re ready to make an investment decision, contact our self-directed IRA experts.

Tags: all things retirement, alternative investments, retirement, SDIRA, self-directed ira