Investors are surprised when we tell them the best hedge is usually cash. We are positive on markets and we typically suggest investors hold only enough cash to reach the ‘sleep at night’ level. We cannot predict the market, and neither can you. ‘Going to cash’ is never a good idea, but holding some cash so you don’t panic in a bad market is never that bad of an idea, either. Cash doesn’t cost anything, and even earns a minuscule amount.
But an index cannot be taken over at a premium, and owning dozens or hundreds of stocks in an index product dramatically reduces single-company risk. Shorting an index is simply an easy hedge against a market decline. The drawbacks are costs — it costs money to short — and also one needs to cover dividends. The dividend on the S&P 500 is 1.5 per cent right now. With shorting costs, the market likely needs to drop about five per cent for this hedge to be successful.