A common theme in this blog is the need to diversify your investment portfolio so that you can manage your exposure to risks. Technically, there is a term for that: hedging. Hedging, as with many finance concepts, is simple at its core – it’s a strategy used to lessen the risk of loss in a certain investment.
“This is more than just the high-flying activities of hedge funds we all read about,” explains Richard. “Hedge funds can invest more flexibly with options to, for example, short an equity or invest in property developments, which often means they are taking on a lot of risk. But the underlying motivation is to use that flexibility to protect investment risks.”
Create a safety net with a hedge
Most of us are long-term investors – we put out money into a fund or other financial instrument for the long haul, until we absolutely need it. And normally, this strategy does not require too much hedging since, as most choices will be stable with relatively steady positive growth.
But, not all of us want to rely on historic figures, especially in this time of shifting eco-political trends all over the world, and sometimes we want to give a potentially risky opportunity a try.
This is where hedging comes in. Whereas the idea of a “hedge fund” may conjure up images of lavish wealth, you would hedge your investment not to ensure a profit, but rather, the hedge is to create a situation where, if your investment loses, you would not have lost as much as if you didn’t hedge.
Perhaps an example will help
A common example involves airlines and fuels costs. There was a time when it seemed like oil prices would never stop rising. As this is a major expense for a transportation operation, most airlines would enter into a futures contract that would guarantee fuel costs as a certain price for a set period. So, if fuel costs went above that set price, the airline would save money as it would still be able to purchase at the lower price. But, as with all investment strategies, there is a possible down-side – the airline would still have to pay that set price, even if fuel costs go below it.
A futures contract is just one of many hedging tools and strategies. Others include pairing or shorting stocks or derivatives such as put or call options, forward contracts, and swaps. In another post, we’ll discuss them in more detail.
Is this really important to know?
Although you may never get involved in a futures contract or a credit default swap, these are still concepts and instruments that you should understand because it is more than likely that the companies you are investing in, either by holding their stocks or bonds outright or through a fund of some sort, is executing more than one of these hedges.
“Almost anything out there can be hedged, from oil to foreign currency to even weather fluctuations, and you had better believe that most major companies and sophisticated investors and financial institutions are leveraging them all in one way or another,” Richard explains.
If you’d like to learn more about how hedging strategies affect your portfolio, or if you’re interested in deploying a hedge on one of your investments, Richard would be happy to discuss your options with you.