Trading as an Insurance Policy

When I explain trading to people, most shudder. "Isn't that kind of risky?"

My answer is that it's not. Just as an insurance policy protects you from some kinds of risk, a good trading strategy protects you from the risk of a recession.

You buy fire insurance or life insurance to protect your family from potentially devastating events. Good traders thinks the same way. Not only do we try to protect our portfolios from damage in case something really bad happens, we want our portfolios to protect our families.

Insurance for a Poor Economy

Can you buy insurance for a decline in housing prices? What if you work for a high-tech firm, and you want to buy protection from an industry collapse like the one that happened in 2000-2002?

If you're a trader, you can. Stocks have momentum, which is the tendency to keep moving in the same direction once they've gotten started. If you're invested in the stock market and prices drop, you can use momentum to sell out and protect your portfolio in case the economy takes a downturn. This leaves you a load of cash if your home declines in value or you lose your job in the tech sector.

Mebane Faber describes the strategy in detail in his book, The Ivy Portfolio.

Making Money During Recessions

You can be even more contrarian and short the market, which is a way to make money when stocks go down. Faber briefly describes this approach in his book.

Shorting typically has poor returns, since stock markets tend to go up over time. But when you combine shorting with momentum, something remarkable happens. Returns go down a little bit, and the strategy's volatility goes up, but its correlation with the stock market goes to zero.

That is, the long-short momentum strategy does not have a tendency to lose money when the stock market as a whole loses money. During large stock market declines like 2000-2 and 2007-9, the long-short strategy actually makes money.

You exchange higher average returns for the ability to receive money when you most need it: when your house goes down in value or when you're about to lose your job. And even though the long-short strategy has lower returns than the original strategy that doesn't short, both strategies still have higher volatility-adjusted returns than an S&P 500 index fund.

Is it risky to trade your money, do better than the market, and protect yourself during recessions? Most people don't realize that you can ask the question that way. That's why it's possible to do better.

This post was inspired by a read-worthy blog entry at Empirical Finance titled Why Growth Stocks are Awesome. Reformed Trader doesn't really think growth stocks are awesome, and neither does Empirical Finance. Click through to find out why.