How to hedge a portfolio, and how to tell whether the hedge works
A hedge is whatever holds up when the rest of the portfolio falls. This guide covers the common ways investors hedge, why hedges fail, and how to measure a hedge on your own portfolio before a crisis does it for you.
What a market hedge is
A market hedge is a holding or position expected to gain, or at least lose much less, when the main part of a portfolio falls. Its value is not its own return but what it does to the portfolio in bad periods: smaller drawdowns, a shorter recovery, less pressure to sell at the bottom.
MEDGE takes its name from this idea: MEDGE stands for Market Hedge. The platform does not sell hedges or give advice; it measures how each holding actually behaves when it matters.
Common ways to hedge
- Government bonds
- High-quality bonds have often risen when stocks fell, especially in recessions with falling rates. When inflation drives rates up, as in 2022, stocks and bonds can fall together.
- Gold
- Gold has often held its value in currency and financial stress, but it can also fall with everything else in a liquidity squeeze and go years without gains.
- Cash and Treasury bills
- The simplest hedge: it does not fall in a crash, but it does not rise either, and inflation erodes it over time.
- Diversification across asset classes
- Combining assets that react differently to growth and inflation, as in the All Weather or Permanent portfolios, spreads the risk instead of insuring one asset.
- Options (protective puts)
- A put option pays out if a market falls below a level. It is direct insurance, with a cost paid every time, whether the fall happens or not.
- Short or inverse positions
- Selling futures or holding inverse funds offsets losses directly, but these positions lose money in rising markets, and inverse ETFs drift over longer periods.
- Currency hedging
- For a euro investor, foreign assets carry exchange-rate risk. Currency-hedged share classes remove most of it, with a cost and different behaviour in crises.
Why hedges fail
Correlations change. An asset that cushioned past falls may fall with stocks in the next one, because the cause of the crisis is different: falling growth, rising inflation, a liquidity squeeze.
A hedge also has a cost: insurance premiums, lower long-term returns, or years in which the protective part drags while the rest grows. The question is not whether a hedge is free, but whether its cost buys the protection you think it does.
What diversification did in practice
| Portfolio | Max drawdown | Worst year | Annual return | Drawdown vs 100% stocks |
|---|---|---|---|---|
| Permanent Portfolio | −17.5% | 2022: −12.5% | +7.0% | 69% |
| Golden Butterfly Portfolio | −19.5% | 2022: −13.3% | +8.4% | 77% |
| Coffeehouse Portfolio | −20.1% | 2022: −14.1% | +8.1% | 79% |
| 60/40 Portfolio | −21.6% | 2022: −17.0% | +10.0% | 85% |
| Three-Fund Portfolio | −22.3% | 2022: −16.3% | +9.1% | 88% |
| Warren Buffett 90/10 Portfolio | −22.5% | 2022: −16.7% | +15.9% | 89% |
| All Weather Portfolio | −23.8% | 2022: −19.2% | +4.4% | 94% |
| David Swensen Portfolio | −24.1% | 2022: −18.4% | +8.8% | 95% |
| Core Four Portfolio | −24.4% | 2022: −18.0% | +11.6% | 96% |
| 100% Stocks | −25.4% | 2022: −19.5% | +16.8% | — |
Backtests of well-known portfolios on total-return ETFs, June 2020 to October 2026, rebalanced yearly, in US dollars, before costs and taxes. Past results do not predict future returns.
How to measure whether a hedge works
- Behaviour in past drawdowns
- Look at what each holding did during the largest falls of the portfolio, not on average. A hedge that is uncorrelated on average can still fall in a crash.
- Contribution to losses
- Measure how much each holding added to or subtracted from the worst periods, holding by holding.
- Stress scenarios
- Test the scenario you fear, including ones where the usual hedge fails, such as stocks and bonds falling together.
- Measured exposure
- Estimate what the portfolio is really exposed to (markets, rates, the dollar, oil) from how it moves, not from the labels of its funds.
Questions
What does MEDGE stand for?
Market Hedge. The name describes what the analysis is for: knowing what protects a portfolio, and what does not, before the market tests it. MEDGE is analytics software, not a hedge fund.
How can I hedge my portfolio against a market crash?
Common approaches are holding high-quality government bonds, gold or cash, diversifying across asset classes that react differently to growth and inflation, and buying put options. Each has a cost and each can fail in some crises, so the useful step is to measure how your actual holdings behaved in past falls and how they would behave in the scenario you fear.
Do bonds still hedge stocks?
Often, but not always. In recessions with falling interest rates high-quality bonds have tended to rise when stocks fell; when inflation pushes rates up, as in 2022, both fell together. Testing both kinds of scenario shows how much your portfolio depends on that relationship.
Is gold a good hedge?
Gold has often held up in periods of financial and currency stress, but its behaviour is not reliable in every crisis and it can go long periods without gains. Its role in a portfolio is best judged by measuring it alongside your other holdings.
Does MEDGE tell me how to hedge?
No. MEDGE measures and explains how a portfolio behaves; it does not give investment advice or recommend buying or selling any instrument.
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Educational content: not financial advice and not a personalised investment recommendation. Risk disclaimer.