The Life Hedge

What follows is a discussion on portfolio theory.

Pretend you are you. You have a job, and you have a portfolio. The economy is expanding, you are doing well at your job, the company is doing well, you’re getting paid and promoted, and everything is great. Also, the stock market is going up, and you’re making money there, too. Everything is awesome.

Then—whammo—a recession. You get laid off by your company, you lose your income, and you struggle to make ends meet. Then, to add insult to injury, your portfolio gets cut in half, too. You were stressed out before, but now, you’re really stressed out. Everything is terrible.

99% of the country lives like this.

I don’t live like this. I construct a portfolio in such a way that I might limp along or be flat during expansions, but explode higher during recessions. So when things are good, I’m making money at my job, but not really excited about my investments, but when things are bad, and I’m losing money in my business, it is more than offset by the gains in my portfolio. So instead of being either deliriously happy or despondent, I am pretty much Even Steven all the time. No stress.

I call this “The Life Hedge.” I dreamed it up after No Worries came out, but it will be a chapter in the next financial book that I write. Your portfolio should not make your life more procyclical—it should instead be a hedge on your life.

I learned this lesson during the financial crisis. I was working at Lehman Brothers, I was getting paid and promoted, everything was great, then—whammo—the firm ceased to exist, and a half million dollars worth of Lehman stock got vaporized. I no longer had a job. Also, world went to hell, and additionally, I had a portfolio full of stocks, which lost about a third of their value. I was pretty stressed out. If I had constructed a Life Hedge, I would have been a lot less miserable. I wasn’t short anything. I had no put options. I did have gold, but if you remember, gold actually went down in the teeth of the financial crisis. I was shit out of luck. There’s nothing quite like the feeling of getting cut in half. So right then and there, I made the decision to never let that happen again.

So what do I do to build a life hedge? I usually have some put options. I am usually short some stuff. I usually have gold or commodities. But I am diversified in ways that you cannot imagine, across the world, in various asset classes. Basically, I want to get far away from U.S. stocks, which are very correlated to the rest of my life. At this particular point in time, I am actually net short U.S. stocks and net long the rest of the world. Layers upon layers of diversification. Look, in a real bear market, it is tough to hide—anywhere—but if you can be down 10% while the rest of the world is down 40%, then that is a good outcome.

So one thing. First of all, not being exposed to U.S. stocks means that I have missed out on a big bull market. That’s ok—I have caught other bull markets, elsewhere. I have never owned a share of the Magnificent Seven, and I am doing just fine. Me, personally—I don’t get FOMO. I don’t get upset when everyone else is making money and I’m not. But I derive a perverse satisfaction when everyone else is losing money and I’m making money. I mean, I suppose you could just avoid all the brain damage and just be in cash all the time, and with Fed funds at 5.5%, you are more than compensated for it. But I have done better than 5.5% in my career. I am not the world’s best investor. I am not putting up Druckenmiller numbers. In fact, I am probably returning about the same as the S&P 500, just without all the heartache that comes with downturns. Because remember, when things get bad, it’s going to be bad for your portfolio, and it's going to be bad for you personally.

People tend to forget this because we haven’t had a bear market in a while. In bear markets, everything gets worse. Divorces go up. Suicides go up. Substance abuse goes up. Happiness, however you measure it, goes down. Imagine a bear market where your income drops or disappears, but the value of your investments goes up 50%. That is what I try to achieve. That is actually the hidden lesson of The Big Short—here you had a group of guys that made a big countercyclical bet and it paid off. Everyone else got poor, and they got rich. I know some other stories like that, too. You know who did well in the financial crisis? Equity derivatives guys. I heard stories of those guys walking into a Best Buy on the ding-dong lows and buying up the entire store for pennies on the dollar.

That’s not to say that you should be a dedicated short seller—that’s different. Stocks usually go up and to the right, so you do need to have some exposure to something. It is very difficult to make a living as a short seller, and also, nobody likes you. There are only a handful of good short sellers out there, and in bull markets, most of them get their shit pushed in. No way to make a living. It’s more art than science, but the goal is to get some long exposure and offset with hedges.

Hedges are insurance. And it’s funny, because people have insurance on their house, they have insurance on their car, they have insurance on their life, but they don’t have insurance on their portfolio. Hence, the tail risk fund emerged as a way for people to insulate themselves from market crashes, though that seems like an extra, unnecessary step. You can do it yourself; you just have to be strategic about it. Again, you achieve this through hedges, shorts, and very wide diversification.

I fear procyclicality more than death itself. Look, I have a wife, a house, three cars, and seven cats. I need to take care of my family. This isn’t a game. This isn’t funny. And inevitably, what happens is that the value of someone’s portfolio goes up, and consumption goes up accordingly. The $30,000 vacation to Greece. The new BMW. The private school tuition. And then a hurricane of a bear market rolls through, and you have to undergo some kind of austerity. I don’t know about you, but I sleep at night. I don’t go to bed at night worrying about some financial calamity. In fact, I go to bed praying for one. I muddle through during expansions, but I get rich during recessions. The newsletter business is somewhat countercyclical, too—my subscriptions tend to go up in bear markets. All this gives me peace of mind.

This gets back to my thoughts about index funds in general: when you invest in an index, not only do you get the returns of the index, which are great, but you also get the volatility of the index. And the S&P 500 is a pretty volatile index. Here I can make a very strong case for active management—a skilled manager can take steps to mitigate volatility—or at least hang out in cash. And it is crucial to have a large allocation to cash. Cash dampens volatility, and is also an option to buy something cheaper in the future. The story not told about the financial crisis is the people with courage, capital, and conviction who hoovered up a bunch of distressed properties in 2010 and made a killing. But they had to have the cash—they had to be liquid. Cash is necessary to take advantage of opportunities—I keep 20% around at all times—at least. And in a positive rate environment, this is a lot easier. But I did it in zero rate environments as well.

People are not good at seeing volatility, so when it happens, it tends to surprise them. Hell, we have an election coming up in six months, and nobody is too sure about whether there will be a peaceful transfer of power. Bad shit can happen. It usually doesn’t, but it can. Hell, we had a pandemic four years ago—who the fuck knew that was going to happen? Volatility is the enemy. The purpose of volatility is to make people make stupid decisions.

The optimists will disagree—everything always goes up. But it’s no fun when it doesn’t. I want to be less happy than you in the good times, and more happy than you in the bad times.