Risk Hedges to Avoid

Risk Hedges to Avoid

By Anthony Criscuolo, CFP^®

We wrote recently on the return of stock market risk from tariffs and trade uncertainty. You know our recommendations are to stay calm, stay invested, and stay diversified. It may also be helpful to discuss some risk hedges you should avoid and refocus your efforts on what you can actually control.

Many pundits will offer up alternative risk hedges to play defense during times of market risk. The three common ones today seem to be bitcoin, gold, and cash. The reality is these are just short-term speculative bets – they too are all risky in some ways, even cash when you consider it in the context of taxes, inflation, and opportunity cost. Holding cash is just part of a market timing strategy – it’s not defense it’s just not playing at all. Let’s go a little deeper into the primary arguments against each.

Bitcoin & Other Crypto Assets

We don’t like crypto assets mainly because they have no true intrinsic value. They trade solely based on investor sentiment or hype. If we can’t understand the underlying value of an asset, we don’t consider it an investment, it’s just a speculative trade. Crypto is a poor substitute as a form of currency due to its volatility, so it is a bad hedge against any worries of a declining U.S. dollar. We prefer international equity exposure to companies doing business in their local currencies, this is a more effective hedge and means of diversification from the U.S. dollar inside your portfolio. We also like to have a small, dedicated allocation to global real estate, which is a good long-term hedge against inflation as owners can pass through rent increases overtime and the underlying real estate assets tend to appreciate at or above inflation. Overall, we are highly skeptical of crypto assets and do not deem them a suitable investment or hedge against market risk. Blockchain technology itself may be valuable, but we prefer to own and invest in real companies, with real assets and cash flows with the ability to grow and innovate over time and through different market cycles. Bitcoin may do great over some period of time, and there are lots of speculators out there willing to buy and sell, but we don’t want to participate.

Gold

Gold is similar to crypto in that it also has no real intrinsic value. It is a tangible item, and you can take physical possession of it, but it has no real utility and it’s not a major input in the production of goods or services. We would prefer to own an equity position in a group of companies that operate as gold miners or dealers. These companies will benefit from higher gold prices, but they can also generate profits and cash flow, cut costs in down periods, and innovate over time. These types of companies are part of a diversified portfolio. This equity exposure to real operating businesses is much more attractive than owning a piece of gold – the future value of which is solely based on the hope a future buyer will find it more valuable than what you paid for it. We have discussed some of the other shortcomings of owning gold as a risk hedge and you can revisit that in our prior article: Why You Shouldn’t Own Gold Instead of Stocks and Bonds.

Cash

While cash feels safe in the short term, after taxes and inflation you are actually losing money over time. Even if you can earn 4% to 5% cash yields, this interest income is the least efficient since it’s subject to your top ordinary income tax rate plus the 3.8% Net Investment Income Tax (NIIT). This means your interest income can be taxed at an even higher rate than your wage income! We recommend any excess cash be added to your overall diversified investment portfolio. A diversified portfolio has more risk than cash, but you are compensated for the risk with higher expected returns over time. A diversified portfolio will have a better opportunity to keep up with inflation, and taxes can be better managed based on the timing of capital gains and by holding some investments which pay tax-exempt interest or qualified dividends vs. ordinary interest income. There is also an opportunity cost to holding cash. If you wait to invest until things seem clear and the risk is reduced, the top returns have already been made. Excess investment returns come from owning risky assets over time. You should not avoid risky assets altogether; instead, you need to own a diversified mix of all sorts of assets to balance the risks. So, cash may seem safe in the short-term, but in the long-term you are essentially just guaranteeing the loss of value – that’s not a risk, it’s just a certainty.

As we have said before, the ideal hedge against market risk is diversification and patience – both of which are in your control. You want to focus on your long-term comprehensive planning, not the day-to-day moves of the stock market. You have much more control over your own spending and savings than you do over the rate of tariffs or what Trump will tweet tomorrow. Also keep in mind, market volatility is an opportunity to invest at cheaper valuations. The figure below helps illustrate what factors you have control over, and the other factors that must be managed by thoughtful and comprehensive planning. 

Good financial planning is not about predicting the future, it’s about planning for the uncertain future ahead. It’s about balancing risks and rewards, planning for your personal cash flows to satisfy your income needs and expenses, meeting your retirement goals, adapting to changing circumstances and tax laws, and living a fulfilling and meaningful life. Market risk is real and there will always be some periods of declines – sometimes major declines. Such periods are good reminders of why we diversify and why we focus on things we can control, like strategic tax planning, minimizing fees and expenses, diversification, asset location, rebalancing to manage long-term risk, and cash flow modeling to understand appropriate savings and withdrawal strategies.

Our strategy is to stay focused on owning a globally diversified mix of stocks and bonds, with an emphasis on long-term total returns and risk management. There will be periods when crypto and gold assets perform well, but we don’t view them as suitable long-term investments, rather they are short-term speculative bets. Pay little attention to predictions and forecasts and avoid the speculative trades that present themselves as “risk hedges” – you are just trading one risky asset for another. Also resist the temptation to sit on cash – you cannot time the markets, and the opportunity cost can be significant.

We are here to help and reassure you through the swings in the markets. Sometimes talking you out of the idea of buying bitcoin or gold is our highest value-add as your advisor. Please reach out to us if you have any questions or concerns. I know it’s boring, but the most ideal hedge against market risk is time and diversification. Focus on what you can control and remember: stay calm, stay invested, and stay diversified. 

Anthony Criscuolo, Senior Wealth Manager

Hightower Advisors, LLC is an SEC registered investment adviser. Securities are offered through Hightower Securities, LLC member FINRA and SIPC. Hightower Advisors, LLC or any of its affiliates do not provide tax or legal advice. This material is not intended or written to provide and should not be relied upon or used as a substitute for tax or legal advice. Information contained herein does not consider an individual’s or entity’s specific circumstances or applicable governing law, which may vary from jurisdiction to jurisdiction and be subject to change. Clients are urged to consult their tax or legal advisor for related questions.