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Should Puts be used to hedge your Long-Term Portfolio?

Many investors use Puts as a protection against sharp market declines. While they did make gains in sharp bear markets, they also have a very high cost.

A recent research made by AQR, about Tail Risk Hedging (one of six papers recognized as “Highly Commended” in the “Best Quant Paper” category of the Savvy Investor Awards 2020), end up preferring Trend over Put.

Trend has been able to combine positive long-term returns with strong performance in most market tail events.

Put did make timely gains in sharp bear markets but lost money on the long run.

Put has a relative edge in fast market drawdowns, while Trend has an edge in slower ones.

Since most of the worst ten months were not the first one within its broader drawdown episode, whereas half of them were the last month within the episode ("Fed Put"), it seems reasonable to assume that trend can catch up in time with the falling market to reduce exposure.

Also from phycological prospective, the high bleeding costs of the Put strategy make it less likely that investors will even achieve the tail rewards at market bear events (will find it difficult to stick with a strategy that underperforms more than five years). So if you can't stick with it, you better find other solution.

In another paper by AQR, about Portfolio Protection, they argued that investors should focus on bad outcomes that unfold over longer periods, as those tend to be more detrimental to the long-term goal of wealth accumulation.

Diversifying strategies such as defensive equities, risk parity, alternative risk premia, and trend-following have more consistently added value over horizons that matter most - as well as on average.

To sum up, using Puts for trading has to do with timing.

If you are thinking of holding Puts as insurance for your portfolio, on a regular basis, then think again. The cost of doing that will hurt your wealth creation, on the long run. There are better solutions for that, including market filters and trend following.

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