Post-mortemCase studyRiskInvesting
The cost of protection, itemised: what a seven-year hedge actually cost
Prem Watsa · Fairfax Financial's 2016 letter to shareholders · 2017
The idea
Fairfax's 2016 letter is an unusually candid account of a defensive hedging programme from start to finish. Since 2010 the firm had run index hedges and deflation swaps to protect capital first. The bill is itemised: 4.4 billion of cumulative net hedging losses and half a billion on deflation swaps, against 2.7 billion of stock gains and 2.2 billion of bond gains. After the 2016 election the hedges came off and bond duration was cut to about a year, producing a 1.2 billion net investment loss. Watsa does not spare the stock picking either: hedging was costly because markets did well and the firm's own selections did poorly. It is the full ledger of what insurance costs when the house does not burn down.
A hedge is a premium paid every year; over a long bull market the premium is the whole story, so account for it as a cost from the start.
When it works
Portfolio hedging decisions, insurance company analysis, and any discussion of tail protection.
When it may fail
The letter's rights do not allow an excerpt here, so read the original for the wording. And the counterfactual, a crash the hedges would have paid in, did not occur; the ledger shows the cost, not the value, of the insurance.
How to use it
Before buying protection, write its annual cost as a share of the portfolio and the number of years you could pay it before the protection had cost more than the loss it insures against. Fairfax's ledger gives the shape of the answer.
Where it came from
Letter Fairfax Financial's 2016 letter to shareholders · Prem Watsa
What the source says. Since 2010 Fairfax recorded $4.4 billion of cumulative net hedging losses and $0.5 billion on deflation swaps against $2.7 billion of stock gains and $2.2 billion of bond gains; after the election it removed all index hedges and cut bond duration to about one year, producing a $1.2 billion net investment loss.
Competing perspectives
Argues against
A handful of outcomes carries a portfolio, and a careerResults come from a few outcomes, so the job is to survive long enough to be there when they arrive.
Connected ideas
Says something similar
Risk is the probability of losing purchasing power, not the volatility of the priceMeasure risk as the chance of ending the holding period with less buying power, which makes volatile productive assets safer than stable unproductive ones.
Concepts
Put it to work on L3VLUP
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