Financial

How To Hedge Your Bets Once You’ve Realized A Mistake Was Made

Like it or not, we are all bettors. To make things sound better, we like to call ourselves investors. But either way, we’re all constantly taking risks in everything we do.

The other day a Financial Samurai reader named Jim challenged me to a $5,000 bet. Surprising!

I was going to go back to Jim with a more friendly-sized bet of $100. However, after giving the wager some thought I decided what the heck. Jim said he owns a lot of warehouses and commercial property, so he most likely can easily afford the wager he offered. Further, I had conviction.

If you don’t take action by betting what you believe to be true, then what’s the point? Talking about something without any skin in the game is a waste of time.

Our $5,000 Bet On The Average Mortgage Rate

After reading my post, Why Higher Mortgage Rates May Be Great For The Housing Market, reader Jim disagreed with my thesis: 4% will be the estimated cap on the average 30-year fixed mortgage rate in 2022.

Calling for a 4% cap on the average 30-year fixed mortgage rate is a relatively aggressive forecast given inflation is currently at much higher levels. However, being more conservative by saying something like, “the average 30-year fixed mortgage rate won’t surpass 5.5%” is not interesting. That’s like forecasting the S&P 500 will be between 3,000 and 6,000 by year end.

Jim went on to write, “I would guess that by the middle of 2023 the average (30-year fixed mortgage rate) will be 6-7%.

When I told him I’d happily wager to take the under, he came back with the $5K bet offer. So I accepted. We traded e-mails and the bet was finalized.

Of course, there is the possibility one of us won’t pay up. But a Financial Samurai, like a Lannister, always pays their bets. So don’t worry about me Jim!

Why I Accepted The Bet

Since starting Financial Samurai in 2009, I have believed interest rates will stay low for the rest of our lives. The interest rate trend is in a downward channel and will unlikely be broken for an extended period of time due to technology, information efficiency, and capitalism. Partially due to this belief, I have invested heavily in real estate since 2003.

I believe current reported inflation levels will subside by the end of 2022 and definitely by 2023. Specifically, I’m looking for inflation to come back under 5% by end of 2022. As a result, the upward pressure on interest rates will also subside by the end of 2023.

Currently, we are experiencing elevated inflation fear. But the key to making money is looking into the future. Extrapolating current events can be dangerous. I liken today’s fear of permanently higher inflation to the fear bearish investors had in March 2020. At the time, bearish investors felt the S&P 500 would keep on crashing into the abyss.

Why Inflation Will Ease And Mortgage Rates Will Stay Relatively Low

Rising long-term bond yields, a stronger dollar, and rising inventories are deflationary. Higher rates slow down borrowing. A stronger dollar makes foreign goods cheaper. And rising inventory means more to choose from at every price point.

Based on the Primary Mortgage Market Survey by Freddie Mac (what we’re using to determine the bet on Dec 31, 2023), the average rate for a 30-year fixed-rate mortgage hasn’t been above 6% in over 10 years. The last time the average 30-year fixed rate was at 6% was in 2008.

Finally, I was offered a high-enough buffer I could not refuse. If Jim had agreed to an over/under line of 5%, I’d still take the under for $5,000. However, he agreed to an over/under line of 6%. Further, with an over/under line at 6%, I was willing to bet much more than $5,000.

Whenever I believe I have greater than a 70% chance of being right, I will make a move. In this case, I believe with 85% certainty the average 30-year fixed-rate mortgage will be under 6% by the end of 2023.

Overcoming The Fear Of Betting With Hedging

Betting on anything can be scary if enough money is on the line. Every time before I’m about to sign escrow documents to buy a house I’m hit with fear. However, the deeper your analysis and the higher your confidence, the less scary the bet will be. The key is to not suffer from Dunning-Krueger, or delusion.

Fear is partially the reason why most of us don’t go all-in on a particular investment. We diversify our investments by investing in index funds, buying smaller positions in multiple stocks, and diversifying into bonds and other assets. At the same time, fear is a key ingredient for achieving financial independence.

With an 85% conviction level I will be right on our bet, that still leaves a 15% chance I will be wrong. All bettors and investors need to be humble enough to know there is never 100% certainty when taking risks. Just know that if you never take any risks, you will unlikely earn outsized rewards.

Therefore, one of the things I can do is hedge my bet, especially once my conviction level drops under 70%. For example, if inflation starts coming in above 10%, there’s probably a 40% chance the average 30-year fixed mortgage rate could jump to 6%. As a result, my expected value of my bet might drop from $4,250 to less than $3,500.

Below is a nice historical inflation chart from the Bureau of Labor Statistics. It also shows Fidelity Investments’ 2022 inflation forecast of 3.5%.

Historical inflation rates chart

How To Hedge Your Bet (Investment)

There are various ways to hedge a bet if you start getting nervous you will lose. Here are three key ways.

1) Offload your risk onto someone else.

Just like how banks who originate a loan can sell it off to a secondary mortgage market, you can sell all or a portion of your bet to other people.

For example, if I wanted to reduce my risk exposure by 50%, I could try and find five other people to take $500 of my exposure each. They would get the same terms as I would get.

2) Become the banker and lock in a win.

Whenever you make a bet with very attractive odds, you have an easier chance of selling your exposure for a guaranteed profit. With my platform, I’m sure I could find enough people to take $5,000 worth of exposure with a lower payout.

For example, I could offload 100% of my risk and offer to pay $4,000 if they bet $5,500. If the average 30-year fixed-rate mortgage is under 6% by the end of 2023, I would win $5,000 from Jim and lose $4,000 to others for a $1,000 guaranteed profit.

However, if the average 30-year fixed rate mortgage is over 6% by the end of 2023, I would lose $5,000 to Jim but make $5,500 from others. When you become the banker, you job is to find the market-clearing price and earn a guaranteed spread.

On a side note, in an inflationary environment with rising interest rates, banks tend to outperform.

3) Invest the other way.

The easiest way equity investors hedge their long investments is by going short. Therefore, to hedge your bet, you could allocate some of your capital that will profit if your bet is wrong.

For example, let’s say it looks like 7.5%+ inflation is going to last well into 2023. Further, I start thinking inflation has a 60%+ chance of going beyond 10%. If so, I could buy inverse bond ETFs like TBF (ProShares Short 20+ Year Treasury Bonds) and TBX (ProShares Short 7-10 Year Treasury) that will appreciate with a rise in inflation and interest rates.

If the 10-year bond yield rises from ~2% today to 5%, then the average 30-year fixed rate mortgage will likely be above 6%. However, if I invest in TBX, it may go up from $25.25 to $34.67 a share for a 37.3% gain.

Therefore, to completely hedge out $5,000 of risk, I would need to invest at least $13,405 in TBX. The best situation is if the 10-year bond yield rises from ~2% today to 4% by end of 2023. In such a scenario, the average 30-year fixed rate mortgage will likely be under 6%, while my hedge in TBX will likely be up about 25% for a $3,351 investment gain plus a $5,000 prop bet gain.

Loading ... Loading …

Hedge: You’re Not Stuck If You Make A Bad Investment

So many times people will give up once they’ve made a wrong bet. The reality is, there is always a market out there for something. Complete loss is rare unless you’re investing in options, angel investments, or undercapitalized equity real estate investments.

If you want to salvage some of your capital, you can hedge well before you lose everything. You just have to be aware enough to know when your investment is moving against you. Then you’ve got to make further analysis about the future.

There are all sorts of ways you can hedge an investment and preserve capital. Here are some daily life examples:

  • Hedge against hitting a glass ceiling by getting your MBA part-time
  • Hedge against taking longer-than-expected to find love by egg-freezing in your 20s
  • Hedge against spraining your ankle by wearing an ankle brace
  • Hedge against rejection by applying to multiple schools

Realize Your Upside Scenario

There’s one last thing about betting I’d like to mention. Think about the upside if you lose your bet.

In my case, if mortgage rates do shoot up over 6%, this likely means my real assets will do well. Rates would only reach this level if the economy is very strong. Therefore, in a way, the $5,000 bet is like a hedge against my existing investments.

If you want to bet, then bet responsibly. Do your research. Find an edge. Don’t be delusional. And bet an appropriate amount based on your income and net worth. Win or lose, be gracious. If you lose, learn from your mistakes so you can improve your odds of winning in the future.

Readers, what are some other ways in which to hedge a bet or investment? Do you believe the average 30-year fixed rate will surpass 6% by the end of 2023? Where do you think the average 30-year fixed-rate mortgage goes from here?

If you’re interested in betting on the average 30-year fixed rate being over 6% by end of 2023, please leave a comment with the wager amount. I will then respond and confirm.

For more nuanced personal finance content, join 50,000+ others and sign up for the free Financial Samurai newsletter. Financial Samurai is one of the largest independently-owned personal finance sites that started in 2009

Source
How To Hedge Your Bets Once You’ve Realized A Mistake Was Made is written by Financial Samurai for www.financialsamurai.com

Related Articles

Leave a Reply

Your email address will not be published.

Back to top button