Hedging in investing is a risk management technique. It is used to limit losses in specific investments. It is not something every investor will need or use, but it is something that every investor should understand and be aware of.
It isn’t just that we should understand hedging for our own portfolios; we should understand it so when we hear news involving hedging we are informed and can draw our own conclusions, rather than relying on someone else’s interpretation.
We purchase investments that we expect to go up in value. We also recognize that what can go up can also go down; the upside potential is offset by the potential for loss.
Hedging is purchasing another investment to reduce the risk of loss in the first investment. It is often described as being analogous to insurance on a house or car, but that’s not a very accurate analogy.
How Hedge Investing Works
To hedge you purchase an investment that can be used to offset potential losses. This can be done by using a derivative investment, or through other techniques.
The key to a hedge investing is a strong negative correlation with the investment whose return you wish to hedge. You want the two to behave strongly in the opposite fashion; if your original investment does well, it doesn’t really matter what the hedge does.
If your original investment loses money, however, you need positive performance from the hedge to offset the negative performance of your original investment.
That is what a strong negative correlation provides: definite movement in the opposite direction.
For example, let’s say you purchase shares in XYZ company. Your long-term expectation for XYZ is very positive, but you are concerned about the potential for loss across the next year or so and would like to minimize that risk.
One strategy would be to purchase a put option on XYZ. A put option allows you the opportunity, but not the obligation, to sell the underlying asset at a predetermined price for a set period of time.
If XYZ declines substantially in value during this time, you can sell or exercise the option to reduce your loss.
The hedge isn’t necessarily the same as the original investment or investments.
You might be bullish on transportation and purchase a number of transportation stocks, but hedge with a put option on a transportation index. That would protect you against a decline in the sector, as opposed to a decline on any of the individual issues.
The Risk Management Aspect
The purpose of hedging is to reduce your downside risk. It also reduces your upside potential.
You typically know in advance what the potential reduction on the upside is; if your original investment does very well, your overall return will be reduced by the cost of your hedge — in our previous examples, the cost of the option.
Your potential for loss is lower with a hedge, but you can still lose.
The range of returns you can expect is narrower as the result of hedging: Your potential upside is reduced and your potential downside is limited. Your return will neither be as great nor as bad as it could have been.
The problem with the insurance analogy is that in insurance your risk is very specifically defined. You know what your potential for loss is and under what circumstances insurance will pay.
Using an option to reduce risk does not provide guarantee against loss; it reduces the potential amount of the loss. That is not the same thing.
Risk and Volatility
Volatility is not the same as risk. Volatility is fluctuations in price in the near term; risk is the chance of losing money in an investment.
Short-term fluctuations, even where the value drops below your purchase cost, are not a good indicator of long-term risk. This is one reason hedge investing is not regularly used by the average investor.
The average investor is — or should be — concerned with long-term performance. The average investor shouldn’t be in volatile investments with money they will need in the near future.
Hedging tends to be a near-term strategy. We typically hedge against what might happen in the next few months out to a couple years.
For most investors, the time horizon is longer than this; the short-term performance is less important than the long-term performance. But that is not true for everyone.
For some the short term is extremely important. If you are a pork processer, the price of pork in the coming months is very important. And you may hedge against it going too high.
If you are the farmer bringing pigs to market, you may hedge against the price going too low. Both are concerned about price changes in the near term. They’re probably concerned about the long term as well, but the near term is very important. Hedge investments are common in the agricultural and commodities markets.
Institutional investors and other large investors may likewise want to hedge near-term performance and make more extensive use of derivative investments. They have a lot of pressure to manage short-term results, making hedge investments a natural fit to limit losses.
The Bottom Line
Conceptually hedging isn’t complex at all — it is simply obtaining an offsetting position to reduce the potential for loss when investing.
It isn’t something that every investor needs to use. But it is definitely something that some investors need to use, depending on their objectives and time horizons.
Hedging is a conservative strategy, as is typical of strategies to minimize risk. You always have a trade-off; you can’t lower your downside risk in an investment without also reducing your upside potential.
If an investor wants to play with more speculative investments, hedging could be a great strategy to reduce their exposure on the downside.