Diversify the Source of Risk Management
Add explicit hedges instead of relying on diversification alone
- Difficulty
- Advanced
- Time to result
- ~months to results
- Steps
- 5
- Confidence
- 95%
Traditional portfolios diversify across assets, but their protection may still depend on correlations behaving as expected. Chang proposes diversifying the source of risk management by adding an explicit hedge to a portion of the allocation. A buffered equity strategy, for example, can sacrifice returns above a predetermined cap in exchange for protection against an initial band of losses. Because the hedge is contractual rather than dependent on bonds rising when stocks fall, it can remain useful during inflationary periods such as 2022. The investor should map existing defenses, stress-test simultaneous losses, compare costs and trade-offs, and introduce hedging without assuming it replaces all diversification. Avoiding part of a drawdown also leaves more capital available to compound during a recovery.
Origin
Chang's experience trading through the 2008 crisis and 2010 flash crash informed Vest's focus on explicit downside protection and defined outcomes.
Core principles
- 01Diversify risk controls as well as assets
- 02Use explicit hedges when correlations may fail
- 03Evaluate protection through full market cycles
- 04Preserve capital to improve subsequent compounding
- 05Match risk tools to the investor's objective
How to run it
- 1
Map existing defenses
List each portfolio holding and identify whether its protective role comes from cash, diversification, expected correlation, insurance, or an explicit hedge.
Pro tip Distinguish a risk-reducing asset from an asset merely expected to behave differently.
Watch out Historical correlation can change precisely when protection is needed.
- 2
Run a correlation-break stress test
Model a period in which equities and bonds both decline, along with relevant inflation and liquidity shocks.
Pro tip Use 2022 as one scenario rather than the only scenario.
Watch out Do not rely solely on average volatility or normal market conditions.
- 3
Select a hedge structure
Choose an instrument whose downside protection, upside limitation, duration, liquidity, and counterparty structure match the objective.
Pro tip Express the desired outcome before comparing products.
Watch out Protection is never free; identify the sacrificed return, fees, and remaining losses.
- 4
Fund a partial allocation
Reallocate a measured portion from existing assets so the portfolio gains a new source of protection without abandoning broad diversification.
Pro tip Compare portfolio-level volatility before and after the change.
Watch out Avoid treating a hedge as an all-or-nothing replacement for stocks or bonds.
- 5
Review through the full cycle
Track whether the hedge reduces losses as designed and whether preserved capital improves recovery-period compounding.
Pro tip Evaluate results across both drawdowns and strong rallies.
Watch out Judging only during a bull market will overemphasize the upside cap.
In the wild
An investor takes a small proportional amount from equities and fixed income and places it in a buffered S&P 500 strategy. Overall volatility may remain similar, but part of the portfolio's protection now comes from an explicit hedge rather than solely from stock-bond correlation.
→ The portfolio gains a second source of risk control for inflationary or correlation-breaking environments.
During a market decline, a buffered sleeve avoids an initial portion of equity losses while the conventional portfolio falls more deeply. When markets recover, the investor begins with more capital available to participate in the rebound.
→ Reduced drawdown improves the mathematical base for subsequent compounding.
Common mistakes
Assuming bonds always offset stocks
Stock-bond diversification can fail during inflationary shocks, leaving the portfolio without the protection expected from historical correlation.
Ignoring the upside cap
Buffered strategies exchange some upside for protection, so evaluating only the downside benefit misrepresents the trade-off.
Timing inflation with commodities
A tactical commodity position may help during inflation but can become a drag when the timing is wrong.
Is it for you?
Best for
It is best for wealth-preservation investors and advisors managing portfolios vulnerable to inflation or correlation breakdowns.
Not ideal for
It is not ideal for investors seeking unlimited equity upside, unable to understand derivative-based products, or investing over a very long horizon with high loss tolerance.
From the transcript
“why not diversify your risk management and hedge.”
“You've introduced hedging as the source of your risk management”
“what in your portfolio is going to save you if twenty twenty two repeats itself.”
From the episode
Financial Products for Hedging with Vest Co-Founder Jeff Chang
Jeff Chang