Hedge Against Your 401k

Most 401k programs out there don’t allow the investor to have very much flexibility in terms of investments.  This is especially true with the ability to short the market.  When confronted with a bear market 401k investors are forced to flee to safety in very low returning “savings account” type funds.  This should not be your only option.  Opening a separate individual account online is very simple with today’s user friendly websites and opens up the world of shorting to anyone.  This gives an investor the ability to at least hedge against a falling market and maybe end up making money in a down year.

To put this in simple terms; lets suppose you have a 401k through work with $50k in it at the beginning of the year…  You have your money in the “large cap fund” within the 401k.  The market has a terrible year and ends down 35%.  This means that you have lost $17.5k in value of that original $50k (just to keep it simple we are not including any of your contributions through the year)  What could have been done?!?  Well if you had a psychic moment and saw the downturn you could have put your $50k into your “savings fund” within the 401k and earned an average of 3% on that $50k. This would have saved your nest egg from that hit, but you could have also made money on the downside.  For example you could have opened up an individual account with the online broker that you pick from our handy online broker user reviews and bought SH (ticker of Proshares Short S&P).  Lets say you put $20k into that account for simplicity.  With SH you would have made 35% based on the market going down 35%.  That’s right you would have made 35% on your money with the market going DOWN!  So let’s add it up and compare:

401k-difference

Now we have to ask you how risky is it to short the market? Isn’t that all you ever hear from financial advisers and CNBC that shorting is way too risky?  Seems risky not to have that option.   It is, however, risky to your fund manager in that he isn’t able to add to his asset collection and make commissions telling to you the classic lines like, “You need to cost average down” or ” This is the time to buy, when it’s cheap.”  You have a choice; you can take control out of their hands or sit back and relax taking the 35% hit on your nest egg.  Leave any thoughts or comments below.

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7 Responses to “Hedge Against Your 401k”

  1. Your scenario above assumes that the S&P declines 35%. What would have happened to the value of your ETF if the S&P would have instead gone up 35%?

    • Rick,
      This scenario is to show the option people have when a market is in a bear market and is going down. Most people are trained to think that they don’t have any options and they have to go down with the ship. Hedging can save your nest egg.
      There is timing involved, but you would be buying SPY instead of SH if the market is in an uptrend. To keep things simple a lot of people hedge when the S&P is below the 200 day moving average and are fully long when its above the 200 moving average.

  2. What you have described above is not hedging, because in your scenario, the investor got completely out of the S&P fund. Thus, purchasing the short ETF is not a hedge against anything; it’s just a speculative play.

    If you truly want to hedge, you would stay in the S&P fund and purchase (or sell) an instrument to limit your losses, probably options. Going long a short ETF like SH would just neutralize that amount in your S&P (minus commissions and fees); might as well get some interest rate off of it instead. Hedging should be cheaper than getting out and back into your underlying position, or else you’d just do that. But the principle remains: if you’re out to make money on a drop rather than protect it, you’re not hedging.

  3. Oh, one more thing: you didn’t take into account the tax considerations of the gain in SH (unless your “hedging” account was another tax-deferred account). Even assuming you’ve held it for a year, the government’s going to take 15% of that $7,000. Holding cash is looking even more attractive. 😉

  4. I know, old post – but I was thinking..
    A way to move money out of traditional IRA and into taxable account, in case you need access to some of these funds without paying IRS 10% penalty might be (if you are long bias S&P) to short /ES futures in IRA and long /ES futures in taxable account. This might allow you to have money flow from IRA to taxable account without the penalty. Your gains are taxed at the 60/40 rule on the taxable account, and if the trade goes against you, you write off your losses on the taxable account.

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