How to protect your portfolio: what hedging really means for long-term investors

US large-cap equities have fallen by more than 20% in a single calendar year six times since 1928, and in each case the investors who fared best were the ones whose portfolios were built to absorb it.

The tools that put a portfolio in that position are known, collectively, as hedging. The word has acquired an intimidating reputation, bound up with derivatives and professional trading desks. In practice, most of what protects a long-term portfolio is simpler, cheaper, and already within reach of any investor.

This article looks at what hedging actually means, why protection matters even though severe falls are infrequent, what diversification can and cannot do, and the everyday tools most investors use to manage downside risk. We close with the narrower, options-based form of hedging (the subject of a companion, more complex piece) and where it fits.

What does hedging mean?

To hedge is to take a step that limits the harm from an adverse move in markets. It can mean constructing a portfolio whose mix of assets limits how far it can fall — assets with limited correlation with each other, assets that move in different directions in different market conditions. It can also mean buying a financial contract — most commonly a put option — that pays out when markets drop, in the way an insurance policy pays out after a loss. 

Severe falls are infrequent, but when they happen, it hurts

Large losses are rare, but they can be damaging. On the historical record, US large-cap equities have posted a calendar-year loss worse than 20% six times since 1928 — roughly once every 16 years. For an investor with a 30-year horizon, the math is simple — it may happen twice. Past performance, however, is not an indicator of future returns or performance. 

These episodes, however, may have a long-lasting impact on a portfolio. Losses and gains are asymmetric: a 30% fall requires a 43% gain to break even, and a 50% fall requires a 100% gain. The deeper the decline, the longer the potential climb back. 

As an example, the worst single year on record, 1931, saw US large-cap equities fall about 44%. More recently, the 2008 loss of 37% took until 2012 to recover in full on a total-return basis — close to four and a half years with dividends reinvested (S&P Dow Jones Indices; recovery per Bloomberg data). Past performance is not necessarily a guide to future performance or returns.

For an investor that is still accumulating, time may repair most of this damage. But for one drawing on a portfolio in or near retirement, a deep fall at the wrong moment can be the difference between a plan that works and one that does not (something called sequence risk). That is why protection is worth thinking about in advance, rather than in the middle of a decline.

Does diversification eliminate risk?

The first line of defence for most portfolios is diversification — holding a spread of assets whose returns do not move in lockstep. Across normal conditions, which make up the great majority of any investing lifetime, it reduces volatility and smooths returns at no explicit cost. It is the closest thing investing offers to a free lunch.

Its limitation shows up precisely when protection is most needed. In a genuine crisis — for example, a black swan event — correlations tend to rise: assets that behaved independently begin to fall together. In 2008, equities, corporate credit, and property declined in unison, and several strategies marketed as market-neutral did not hold up. The assets that did their job that year were a short list — high-quality government bonds, gold, and cash. US 10-year Treasuries returned about 20% and gold about 4%, while equities fell. 

Diversification is also conditional, not guaranteed. In 2022, an inflation shock pushed high-quality bonds and equities down together: US Treasuries fell about 12.5% and the broad US bond market about 13%, alongside a falling stock market. The lesson is not that diversification fails, but that not all bonds are necessarily safe assets through every market downturn.

A final note on diversification: a diversified portfolio may partially protect you from the impact of an equity market downturn, but it is unlikely to totally insulate you from it, even if some of the assets have negative correlation with equities. That is because equity allocations are typically larger — especially in the accumulation phase — and this is a good thing. An excessively prudent allocation to equities may be good in drawdown years, but it prevents you from capturing the upside in the “good” years, which, according to the data shown above which refers to US equity markets, are typically the majority.  

Can you hedge without increasing costs?

None of the following needs a trading account or a derivatives licence. Together, they account for most of the downside protection a long-term investor needs.

• Right-size your equity exposure. The most direct way to carry less risk is to hold less of the riskiest asset. Matching the share of equities to your time horizon and genuine loss tolerance does more than any overlay. But beware — being excessively prudent can also potentially lead to lost opportunities, especially at a younger age. So a truly honest assessment of your capacity and willingness to take risk is crucial. 
• Hold a defensive sleeve. A portion in high-quality government bonds, and for some investors a small allocation to gold or cash, is the part of a portfolio designed to hold up in a crisis. 
• Keep a liquidity buffer. Severe falls often coincide with a need for cash. An adequate cash reserve means you are not forced to sell at the bottom to meet a liability.
• Rebalance on a schedule. Trimming what has risen and topping up what has fallen is a disciplined, counter-cyclical habit that quietly sells high and buys low, and keeps risk from drifting upward unnoticed.
• Protect your behaviour. Over every rolling 20-year period in the historical record, US large-cap equities have delivered a positive total return in US-dollar terms. The largest avoidable risk in a severe fall is not the drawdown itself but the decision to sell at the bottom and miss the recovery. Past performance is not necessarily a guide to future performance or returns.

What is options hedging?

The tools above are sometimes called “natural” hedges: they protect by design rather than by contract. There is also an explicit form. An investor can buy a put option — the right to sell an asset at a set price — which behaves like an insurance policy, paying out when the market falls below that level.

It is precise and immediate, which makes it useful around a specific, short-dated risk, or for an investor who genuinely cannot tolerate a particular drawdown. But protection bought in the options market carries a recurring premium, and that cost compounds against a buy-and-hold investor over time. For most long-term portfolios, it is better understood as a specialist tool than a standing feature.

How option hedging works in detail — what the premium pays for, why it has historically cost more than it has returned, and when it earns its keep — is the subject of a companion article: “The price of protection: how option hedging works"

What is currency hedging?

Currency hedging addresses the risk of owning foreign assets, which in practice means you own two assets at once, the asset itself (a stock, or a bond, for instance) and the currency it is priced in. A Singapore-based investor holding US equities or US Treasuries earns the asset’s return in US dollars, then converts that result back into SGD at whatever exchange rate prevails. Movements in that rate add a second layer of return — and of volatility — that has nothing to do with how the underlying investment performed. Hedging removes most of it: using currency forwards, a portfolio can lock in an exchange rate and isolate the asset’s own return from swings in the currency. It is a risk decision — the aim is a steadier result in your home currency. 

But hedging, as we saw, is not free; for foreign exchange, the cost broadly tracks the interest-rate differential between the two currencies, which can run as a benefit or a drag for portfolio returns. Whether it is worth paying turns on how large the currency’s swings are relative to the asset they sit on — which is why the answer differs sharply between bonds and equities.

Investment implications

Hedging is better understood as a property to build into a portfolio — which can or cannot translate into an additional asset purchase (for instance, as it happens with options). In our view, some level of protection for a long-term investor can be achieved through a portfolio that is well diversified, and that is rebalanced with discipline (because panic selling can do more damage than the market drawdown itself). Beyond that, there are specific tools that can help protect against a specific risk, but they are more complex and can be expensive, and are typically built for sophisticated investors. 

On one hand, explicit hedges such as options offer exact, immediate cover and can protect against specific risks. On the other hand, that precision is rented at a price that can decrease returns for a long-term investor, while allocation, diversification, and rebalancing deliver much of the same protection at far lower cost. The goal is not to eliminate every fall (that is neither realistic nor necessary) but to ensure that when one arrives, both the portfolio and the investor can withstand it.

An Endowus adviser can help you set an allocation matched to your horizon and real tolerance for loss, so your portfolio is positioned before the next downturn rather than during it.

Frequently asked questions

What does it mean to hedge a portfolio?

It means taking steps that limit the damage from a market fall. That can be structural — holding a mix of assets that do not all fall together — or explicit, such as buying a put option that pays out when markets drop. For most long-term investors, the structural route does the bulk of the work.

Can I protect my portfolio without using options or derivatives?

Yes. Setting an equity allocation you can hold through a downturn, keeping a sleeve of high-quality government bonds and cash, maintaining a liquidity buffer, and rebalancing on a schedule together provide most of the downside protection a long-term investor needs, with no premium to pay.

Does diversification protect me in a market crash?

Partly. Diversification reduces risk in normal conditions, but in a severe crisis correlations tend to rise and many assets fall together. A defensive core of genuinely safe assets — high-quality government bonds, and for some investors gold or cash — is what tends to hold up when equities do not. All investments carry risk, and past performance is not necessarily a guide to future performance or returns.

Can you buy a put option to protect your CPF or SRS portfolio?

Investors using the Central Provident Fund Investment Scheme (CPFIS) or Supplementary Retirement Scheme (SRS) generally cannot trade options. For these long-horizon portfolios, the practical levers are the equity-to-bond allocation, broad diversification, and periodic rebalancing — the same tools that have historically substituted for explicit protection at lower cost. Returns on CPF monies invested through CPFIS flow back into your CPF account.

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