The Hedged Life

An unconventional route to happiness (or at least less stress) occurred to me back in 2000.  I elaborate on it here for the first time…

Back in 2000, I was stopped at a Chevron (CVX) fuel station and was filling my car up with gasoline which, at the time, was selling for a record price.  As I was still a student at UC Davis at the time and was not working, this financial hit would normally have perturbed me.  But not that day…  On that day, I was staring up at the brightly lit sign advertising the high prices with a big smile on my face.

You see, the Ames family had recently inherited a number of shares in Chevron (CVX).  I do not recall the exact number of shares, but they yielded a dividend income in excess of $18,000 a year.  This sum was (and still is) significantly in excess of the total fuel budget of our family.  So, I knew that I was essentially filling up the tank for free, courtesy of Chevron (CVX), as our annual gasoline bill would be covered many times over by the dividends from the Chevron (CVX) shares.  Not only that, I knew those record prices would help to support not just Chevron’s share price, but also a future stream of dividend payments.  I was happy to have record prices.

In other words, I was hedged…  Unless you’ve experienced this, it is perhaps hard to understand how great this felt, but I assure you that it is incredibly liberating.  The point is not to beat the market–who knows how Chevron (CVX) is going to do? Instead, it is to seek equanimity in an economy that is full of risk.

I frequently hear people complain about high fuel prices or high medical bills or about Wall Street investment banks they think have ripped them off.  Now, imagine flipping that dynamic completely around and being happy about high fuel prices or about Wall Street banks ripping people off!  At the risk of sounding like a snake oil salesman, you can achieve that goal quite simply and in the process bring less stress into your life.  Don’t complain about Wall Street banks ripping off Main Street – Just buy shares in them.  Then you’ll be delighted to hear about Goldman Sachs (GS) or Morgan Stanley (MS) ripping someone off.  Worried about high medical bills?  Buy shares in Johnson & Johnson (JNJ), Pfizer (PFE) or Aetna (AET).  High fuel prices?  Buy shares in Chevron (CVX) or Valero (VLO).

So, how does this work?  

Here’s an example:  Suppose you live in Northern California and, therefore, most likely obtain your electricity from Pacific Gas & Electric, or PG&E as it is more commonly known.  The ticker symbol for PG&E is PCG and a quick check of PCG reveals that the shares are currently trading for a price of $42.50 with a yield of 4.2% (or $1.82).  Now, let’s suppose for the sake of simplicity that your bill from PG&E works out to an average of $100 a month.  This means you have $1,200 (12 x $100) in annual exposure to PG&E that needs to be hedged.  To hedge this exposure, you could purchase 660 shares of PCG.  This would provide you with an annual dividend income from PG&E of exactly $1201.20 based on the current payout offered on the shares.  There you have it.  Your electricity bill is hedged.  Go ahead and crank that air conditioner up!  Actually, don’t because it is bad for the environment, but you see where I’m coming from.

This concept can be applied to almost every financial burden you face.  Have an expensive new plan with Verizon (VZ) for your iPhone?  Make Verizon (VZ) pay for it by buying the necessary number of Verizon (VZ) shares.  If you rent an apartment and wish to hedge your exposure to rent payments, you can simply purchase shares in a real estate investment trust (REIT) that owns apartment buildings.  It would be great if you could purchase shares in a REIT that actually owned your apartment complex, but this seems unlikely given the number of private rentals out there.  So, you may not be able to hedge with the exact owner of your apartment, but is having someone else pay your rent for you really that bad?

If you have purchased a home and are making mortgage payments, you can buy shares in the bank to which you pay your mortgage.  If this is not possible, you can buy shares in another bank that issues mortgages and have someone else pay your mortgage for you.

And, of course, this idea can be taken to extremes…  

You can buy shares in the manufacturer of your automobile or motorcycle and have them pay for it.  You can buy shares in an airline that you fly on and have them pay for your flights.  You can buy shares in the supermarket you patronize and have them pay for your groceries.  And you can break it down even further.  For example: Suppose you like Guinness beer and purchase it often from the grocery store. You could buy shares in Diageo (DEO) which is the parent company of Guinness and hedge your beer purchases that way.

What if the company doesn’t pay dividends?

This is a problem with a company like Netflix (NFLX) that retains all of their earnings and it does make things a little more complicated.  One option is to purchase the bonds issued by the company in question and to cover your bill with interest payments from the company rather than dividend payments.  If this is not an option either, you can purchase a competitor to the company you are trying to hedge against that does pay dividends and cancel out your exposure that way.

Also, bear in mind that dividends are not essential.  Apple (AAPL) does not pay dividends and many of you probably have an Apple (AAPL) product in your home that you could hedge against.  You could pay for your iPad or iPhone by selling some of your Apple (AAPL) stock that has appreciated in value.  Or you can simply try and find contentment with the idea that even if you are not receiving a direct payout, you own a piece of the business to which you just contributed by making a purchase and as a partial owner, you share in its success and profits.

And, sadly, it must be said that you may encounter a situation where it just isn’t possible to find a perfect hedge.

What about taxes?

This is a little more difficult because receiving an income generates additional tax liability.  You do have options though.  The simplest option would be to maintain all of your assets within a Roth Individual Retirement Account (Roth IRA) or the new Roth 401(k) should your employer be flexible enough to provide this option.  You’ll likely have a greater chance of success with the Roth IRA, however, given that you direct investments within this account yourself. The advantage of the Roth, of course, is that any income one receives from a Roth account is entirely tax free due to your having paid the tax when first depositing money into the account.  So, a Roth account = zero tax liability.

Another step you might take would be to buy shares in companies that receive our tax dollars.  So, for example, you might purchase shares in Boeing (BA) or Lockheed Martin (LMT) which both receive large government contracts.  They both currently have attractive dividend yields and you could receive your tax dollars back using this circle of payments.

However, you still would be liable for  a percentage of the income you received from the government contractors.  So, to cover that liability, one could purchase municipal bonds.  The interest payments from municipal bonds are tax free.  So, you could do a hybrid portfolio between the shares of government contractors and municipal bonds or you could take the Roth route.  This is, admittedly, an extreme example, but I wanted to demonstrate that pretty much any financial obligation can be hedged away.

What about your employer?

You might expect me to suggest buying shares in your employer to offset a bad day at work, but this is a very different situation and requires a different sort of hedge.  Your biggest asset is almost certainly one that doesn’t show up on your bank or brokerage statements. It’s your earning potential. The simple rule here is: Don’t make this risk worse by owning stock in your employer. If the company sinks, you’re out of a job and in the poorhouse (Think of the employees of Worldcom, Enron or Lehman Brothers).

If your employer is offering its own stock as part of your 401(k) plan, reject it. If stock is given to you, sell it as fast as you can.

More unorthodox than lightening up on employer stock is the notion of taking an outright bearish position in the industry where you make your living. If you work in Silicon Valley, for example, you could buy some out-of-the-money puts on the Technology Select Sector SPDR (XLK), an exchange-traded fund. If the sector goes through the same sort of shakeout it did beginning in 2000, this long-shot bet would provide you with a cash payout to cushion the blow.

Most likely, the put options will expire worthless. The point isn’t to buy the puts expecting a payout. Instead, look at them as offering the same sort of protection for your career that fire insurance does for your home.

Suppose you and your spouse both work as architects. That means your household income is completely tied to the real estate market. Consider cutting the financial damage you’ll suffer in an industry rout by investing in puts on the SPDR S&P Homebuilders ETF (XHB). You work at Citigroup? Maybe you should own some long-dated put options on its stock.  

If you want to hedge against a bad day at work, the best way you can do that is to grow your net worth to the point where you could retire at any time.  That way you are working because you choose to and not because you have to.  And that makes all the difference in the world!

*****

Do I do all of this myself?  I’m afraid not.  I don’t have enough money yet to do as I outlined above and to still diversify properly, but I’m intrigued by the idea.  Until then, most of my money remains in index funds.